At first glance, the key driver behind this trend appears to be risk-sharing, but the recent Pepper Hamilton LLP / Mergermarket Study provides a more telling look at why co-investments are on the rise.
by Bruce K. Fenton
The hottest trend among private equity groups is co-investment. Private equity firms are increasingly seeking to involve other investors in their deals, and contributions from co-investors are becoming more significant portions of the funding for acquisitions. A recent study sponsored by Pepper Hamilton LLP in association with Mergermarket, “Joining Forces: The Co-Investment Climate in Private Equity,” investigated these trends and found that 100 percent of surveyed funds offer co-investment opportunities. A majority of general partner respondents also said they were actively exploring investment opportunities that would enable their funds to offer occasions to co-invest.
At first glance, the key driver of this trend appears to be risk-sharing, a common rationale when pooling capital. Indeed, 26 percent of private equity firms cited this as the primary reason for the increase in co-investments. A closer analysis, however, provides a more telling look at why co-investments are on the rise. Other driving forces—and the percentage of respondents who named them—include:
These key drivers provide insight into current developments in the private equity space, as well as the primary benefits of co-investment. As investors decrease the number of funds they invest in, fundraising concerns have become more important to private equity firms. Even when not actively raising capital, they must focus continuously on fundraising. One way they do this is by offering co-investment opportunities, which can directly facilitate the fundraising process and indirectly help by establishing relationships with new potential investors.
Co-investment allows private equity firms and investors to establish a history of investing together, which the private equity firms can capitalize on later by offering a co-investor the chance to invest in the firm’s next fund. Private equity firms can also use co-investments to facilitate differentiation and specialization, and to capture high-quality partners, particularly in the private equity firm’s key industries.
Despite these benefits, co-investment relationships are complex, and private equity firms and investors face regulatory hurdles. In the Pepper/Mergermarket survey, 76 percent of respondents cited regulatory scrutiny as one of the biggest challenges to co-investment.
There are some potentially costly regulation-related concerns for co-investments. Co-investment vehicles are required to maintain separate books and records and undergo an annual audit, and they may be subject to U.S. Securities and Exchange Commission examination. They are also subject to scrutiny around fiduciary dutyand disclosure-related concerns. For example, offering to waive the management fee or carried interest for the co-investment opportunity may raise concerns, and certain transaction fee and expense terms must be properly examined for conflicts of interest so as not to invoke regulatory scrutiny.
To overcome these challenges, private equity firms must focus on providing enhanced disclosures during the fundraising process and developing policies and procedures that reflect industry best practices. By insulating themselves from liability in this environment of enhanced regulatory scrutiny, they will be able to maximize their competitiveness by continuing to offer co-investment opportunities.
With a tremendous amount of capital remaining to be deployed, dealmakers are forced to move more carefully before pulling the trigger. The latest study from PitchBook reviews recent trends.
While most global PE trends these days are pointing downward, which is argued as a natural part of the up-and-down investment cycle, there were some 1Q 2016 numbers in PitchBook’s U.S. PE Middle-Market Report which caught our eye.
81.5% –> 1Q 2016 quarterly increase in the lower middle market segment deal value
$47 billion –> last quarter’s capital invested in core middle market transactions, the most since 1Q 2015
79% –> Quarter over quarter drop in upper middle market deal volume
7.4 years –> median holding period for a middle market company exit via corporate acquisition in 1Q 2016. (2015’s median was 5.3 years)
68% –> 1Q 2016 MM funds closed with between $100M and $500M in commitments, up from 59% in 2015 and 52% in 2014
PitchBook defines U.S. middle market activity as companies acquired through buyouts valued between $25M and $1B; lower middle market: $25M to $100M, core middle market: $100M to $500M, and upper middle market: $500M to $1B.
The volatility in 2016 will create uncertainty and a wait-and- see mentality may set it. Will valuations come down for PE investors in 2016, and will it be more difficult to lever up?
This commentary is disseminated in Japan by The Blackstone Group Japan KK and in Hong Kong by The Blackstone Group (HK) Limited.
Here we are with the 31st edition of The Ten Surprises. As loyal readers know by now, my definition of a Surprise is an event I believe is probable, with a better than 50% chance of happening during the year, but which the average professional investor would only assign a one-in-three likelihood of taking place. Over the years I generally have five or six of the Surprises pretty much on target (they have multiple components), but I don’t develop the list to get a high score. My objective is to present concepts that I believe could have an impact on the financial markets but are generally unanticipated by most investors. I would describe my 2015 edition as below average after a good year in 2014. I had a number of Surprises partially “right,” but I missed several important events, including the terrorist attacks in Paris and California, the delay in the increase in short-term interest rates by the Federal Reserve and the weak performance of the U.S. equity markets.
My first Surprise last year expected the Federal Reserve to raise rates early in the year rather than in December, so I got this one clearly wrong. My reasoning was that the Fed had kept rates near zero throughout the recovery and was anxious to move to a more normal policy position. For that to happen, the governors had to feel that the United States economy had developed enough natural momentum on its own to continue growing with less monetary accommodation. Because I believed back then that the economy was headed toward a 3% real growth rate by the end of 2015, I thought the Fed would have the confidence to act early. As events developed, the economy was weaker than I anticipated and the Fed delayed increasing rates until the end of the year (even though the economic data were mixed at the time of their decision).
The second Surprise was my expectation that cyber terrorism would become a serious problem during the year. Foreign computer-savvy operatives are clearly using techniques to invade the networks of both corporations and government agencies. While this problem has existed in a minor way in the past, it has escalated significantly in 2015. So far, however, the cyber security efforts at financial institutions seem to be working, given that no major bank has been forced to suspend service to its depositors. Nonetheless, the risk is self-evident and further efforts by cyber rogues are likely to create major problems in the future.
The third Surprise was that the Standard & Poor’s would rise 15% in 2015. At the beginning of the year, most forecasts by analysts and strategists were for a 10% increase. The surprise would be a market that either did better than that or was down for the year. Since I was optimistic that the U.S. economy would continue to grow during 2016, I opted for the positive view. As it turned out, the combination of a strong dollar and declining oil company profits caused S&P 500 earnings to decline. As a reflection of this, the index saw a decline of less than 1%, a far cry from my estimate. Concern about the Federal Reserve raising short-term interest rates hung a cloud over the market all year.
The controversial decision by Mario Draghi to increase monetary expansion at the European Central Bank was my fourth Surprise, and that turned out to be right. He recognized that without a vigorous program of monetary stimulus, Europe was in danger of moving back into recession. He had said earlier that he would “do whatever it takes” to prevent another recession and he made good on that promise in 2015. As a result, the euro weakened against the dollar, helping European exports and diminishing overseas earnings of American companies. The Surprise further suggested that Europe would suffer a recession anyway and that Germany would be particularly hard hit because exports to China and other trading partners would decline. Happily, Europe had a better year than that with the economy growing at more than 1%. Europe, like the United States, would have had better results with more fiscal spending, but the various parliaments were not supportive of that policy. Politically, there was a shift to the right, as I expected.
I focused on Japan in my fifth Surprise. I thought Shinzo Abe’s combination of fiscal and monetary stimulus would enable the economy to achieve modest growth. The second and third quarters were in recession, although the fourth quarter is now expected to show real growth of 3%. I thought the Nikkei would be flat in yen and down in dollars. As it turned out, it was up in both yen and in dollars, so I was correct on the currency depreciation, but the market did better than I thought it would.
I was right in my sixth Surprise, which said that the Chinese would acknowledge that their economy was no longer growing at 7%. They also required more fiscal and monetary stimulus to prevent a hard landing. The government seems to have deemphasized its rebalancing program (which favors consumer expenditures over investment) to achieve growth. Fewer jobs were created in 2015 than desired, but we did not see the publicized popular protests that I feared. In addition, China did not mount the major effort to deal with its pollution problems that I expected.
In the seventh Surprise I said that the drop in the price of oil would push Iran to reach an agreement on its nuclear program. I don’t know whether a decline in the price of Brent oil into the $40s was the trigger, but a deal with Iran was reached amidst considerable controversy on both sides. Verification is the principal U.S. concern. As a result, there was no significant rally in world equity markets after the accord was signed.
In the eighth Surprise, as I expected, a peace accord between Russia and Ukraine was agreed upon, giving Eastern Ukraine autonomy. On the other hand, I thought Vladimir Putin’s popularity would weaken and he might resign, but that was clearly wrong. Wishful thinking, I guess. Putin remains in firm control of Russia and his desire to establish himself as an international power figure remains unabated. As part of an attempt to achieve his objective of being viewed as a world leader, he used military force to back Bashar al-Assad in Syria. The last element of this surprise, that the price of Brent would rise toward $70 by year-end, did not happen.
For the ninth Surprise, I thought there would be trading opportunities in the high yield market. There was a narrow window in April–May where this was true, but high yield was down for the year. Spreads with Treasurys, while narrowing in a rally during much of the year, widened at the end. This volatility created both opportunity and danger, particularly in the energy and commodity-related lower-quality high yield sector of the market. China’s weakness caused a second leg down in this asset class in the last half of the year.
Finally, in the tenth Surprise I thought the Republicans would try to position themselves as the party that could get legislation passed in Washington. At year-end, under the new House Speaker Paul Ryan, the budget bill did receive approval. I did not anticipate the rise of Donald Trump and Ben Carson and the fractious divide in the party that would develop during the debates. At this point, how this will play out at the convention is difficult to predict. The party establishment believes that a ticket headed by extremists would lose in a presidential election, but the extreme candidates are far ahead in the polls and will be difficult to ignore. The Keystone pipeline expansion was rejected in contrast to the view in my Surprises.
So here are the Surprises of 2016. I will discuss them in detail in my February essay.
Every year there are always a few “also rans” that do not make the Ten Surprises because either I do not think they are as relevant as the ones I picked or I do not have the conviction to say they are probable (better than 50% likely).
There they are – The Ten Surprises for 2016 and the “also rans.” Now let’s see how they work out.
From October through the end of the year I meet with dozens of friends, colleagues, journalists and self-identified “big thinkers” in search of the best surprises for the following year. I want to thank especially George Soros, who has helped me on the surprises for three decades; my Third Thursday discussion group of former research directors who always have provocative suggestions; Gideon Rose, editor ofForeign Affairs; Jonathan Tepperman and others at the Council on Foreign Relations; and my good friend Richard Chilton. They have been helpful, but the Surprises are my own and, right or wrong, I take responsibility for them.
I am making some changes in the Radical Asset Allocation portfolio. I am reducing Global Large Cap Multinationals from 10% to 5% because I believe their price-earnings ratios reflect the corporate prospects. I am also increasing European equities from 5% to 10%. I am eliminating my long-held 5% gold position because I do not expect much movement in the metal over the next year. I am increasing cash from 0% to 5%. Other allocations remain the same.
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