Buyout fund investors look to partner on deals
Saturday February 11, 11:25 am ET
By Michael Flaherty
NEW YORK (Reuters) - Pension funds, university endowments and other institutions that invest in private equity funds are looking for a more direct role in the deal action.
As a result, those pricey private-equity buyouts are about to get even bigger.
The midmarket buyout arena, where the value of deals ranges from the tens of millions to several hundred million dollars, will feel the bulk of this trend.
With an added layer of buyout investors to contend with, the already highly competitive midmarket will have even more well-heeled players. That could spell trouble for midsize buyout funds struggling to find deal partners.
The institutional investors are looking to expand into what the private equity world calls co-investing, or buying a piece of an acquisition that a buyout fund is purchasing.
This direct investment in a deal allows the institutions to deploy capital faster and pay lower fees.
Normally, these investors take a different approach. They allocate money to the funds and wait for a nice return as the funds buy up several, in some cases dozens, of companies and sell them later for a premium.
Co-investing is not new. But more and more, buyout fund investors -- commonly known as limited partners -- are setting aside larger sums of money, albeit not huge amounts, to directly invest in deals.
The reason: it's cheaper.
Limited partners are under pressure to reduce fee costs. At the same time, they have massive amounts of money to invest from their returns on private equity funds.
"We're looking to get the best returns we can, and this is a way," said Chris Wagoner, senior investment officer for private equity at the Los Angeles County Employees Retirement Association.
Generally speaking, limited partners pay a 2 percent management fee to their buyout funds, which in turn are allowed to keep 20 percent of the "carry," or gains.
Co-investing, however, typically comes with a 1 percent management fee and 10 percent carry. The idea is that the limited partner will be an active participant in the deal, so why not reduce the fee for their efforts?
The concept is catching on.
The California Public Employees' Retirement System has said it wanted to reduce its buyout fund relationships and planned to explore co-investing. CalPERS, the largest U.S. pension fund and an investor in 135 private equity funds, currently has a small co-investment fund.
"Co-investing is a cost-effective means of putting pretty sizable amounts of money into work in private equity," said Leon Shahinian, senior investment officer at CalPERS. "If you have great relationships, it could make a lot of economic sense."
Shahinian stopped short of saying CalPERS would expand into co-investing, but several sources familiar with matter said the fund planned to do exactly that.
Co-investing, while attractive to limited partners, comes with risks.
When investing in a private equity fund, a limited partner is placing its faith on a wide portfolio of companies. When co-investing, it is betting on one or a few individual deals.
"It's one thing to be invested in a fund," Shahinian said. "But if something goes drastically wrong with a portfolio company ... it could be a pretty messy situation."
CO-OPERATING
The Oregon Public Retirement System, another major limited partner, is seeking more co-investments.
"It's definitely a policy we've been pursuing more aggressively," spokesman Kevin Max said. "The fee structure is better, and it gives us the ability to act quickly and take advantage of a deal that pops up."
The $1.5 billion that OregonPERS allocated to Kohlberg Kravis & Roberts Co.'s new buyout fund included a $187 million co-investment piece, Max said.
More co-investing is also expected to reduce the size of club deals, where many firms team up on an investment.
As the thinking goes, why bring in a buyout competitor when you can call on one of your limited partners?
"It allows midmarket firms to do bigger deals and do them alone," said Hamilton James, president of the Blackstone Group, one of the largest private equity firms.
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