It's complicated! Private equity's knotty links with investors

Tensions are building as a growing number of institutional investors, such as CPPIB and Ontario Teachers, take to direct investments. Regulators are watching the trend closely.

Private equity firm KKR and Canada's largest pension fund, CPPIB, are jointly bidding for Bharti Infratel, a deal which could be India's largest private equity deal ever at around $5 billion. 

But the relationship doesn't end there. CPPIB has long been a big investor in KKR's Asian funds and recently hired Gloria Song, who used to make investments on behalf of KKR.  

Sophisticated investors such as CPPIB and Ontario Teachers’ Pension Plan are staffing up in Asia, inserting themselves into the deal-making mix, learning and building contacts in the hope of boosting their returns on investments.

The result is an increasingly complex web of relationships between private equity firms and their largest investors that US regulators worry is causing conflicts of interest.  

“Asia is a growth market for us,” said Olivia Ouyang, a director at Ontario Teachers, which has about $28 billion invested in private equity globally and is at the forefront of co-investing with private equity funds and leading their own deals around the world.

CPPIB for instance hired Mark Machin in 2012 from Goldman Sachs Asia and in May named him global CEO. In turn Machin put Suyi Kim, a private equity expert, in charge of Asia in June. 

Institutional investors and sovereign wealth funds co-invested with private equity in 74 transactions worth $36 billion in 2016, according to consultant Bain & Co. These mega-investors have mainly led deals in the US and Europe but financial sources the trend is on the rise in Asia.

According to a survey by private equity data provider Preqin in September 2015, 30% of investors are targeting Asia co-investments, and that percentage is growing. Singapore’s sovereign wealth funds, Temasek and GIC, have long made direct investments globally and are being joined by funds around the world. 

SWFs alone were involved in 10 of the market’s 22 megadeals in Asia Pacific last year, according to Bain & Co.’s 2016 private equity report.

This evolution, from passive investor to partner to rival, has increased the complexity and tension between private equity firms, also called general partners (GPs), and their largest and savviest investors, known in the industry as limited partners (LPs).

“There is an increasing conflict between LPs wanting to be GPs and GPs trying to fend them off,” said Eric Marchand, who is responsible for Asian primary and co-investments at asset manager Unigestion. “I’ve had a few situations where the GP has asked me to sign a non-solicit [agreement].” 

Those tensions are likely to keep on rising as more pension funds and insurers seek their own slice of the private equity pie.

In one high-profile example, private equity firms MBK and TPG emerged triumphant from a fierce bidding war in October to buy Hong Kong-based telecoms firm Wharf T&T for a hefty HK$9.5 billion ($1.22 billion).

Their toughest competitor was another telecoms firm, HKBN, whose biggest shareholder is CPPIB. According to a person familiar with the matter CPPIB was actively involved in the deal negotiations and offered to help with the financing of the acquisition.  

CPPIB has also worked alongside MBK in deals. Only last year the Toronto-headquartered firm invested $534 million alongside MBK in its $6 billion acquisition of Tesco’s South Korean business Homeplus, Asia’s largest-ever buyout.

The Wharf T&T deal went down at a time when both TPG and MBK are trying to raise billions of dollars in capital for new Asian funds from investors.

Risk and reward

The world’s biggest institutional investors are seeking out high-risk, high-reward alternative asset classes to help bolster returns in the face of record low, even negative, interest rates on fixed income investments around the world.

FinanceAsia's sister publication AsianInvestor’s survey in August of the region’s largest 300 asset owners, the AI300, showed their clear intention to boost allocations to private equity over the next 12 to 24 months. 

Beyond just committing capital to pooled funds for private equity firms to manage on their behalf, some of the largest and most sophisticated investors are using their clout to push for co-investment opportunities to eke out an even better result. Almost two-thirds of LPs reported their co-investments had outperformed overall private equity portfolios in recent years in a survey by Coller Capital of 110 institutional investors in private equity between March and April.

Click for full view

The Canadian pension fund made $182 million this year when it sold its 23% stake in Key Safety Systems to a Chinese buyer, after co-investing in the company in 2014 with Chinese private equity fund Fountainvest. The latter is led by another Goldman Sachs alumnus, Frank Tang, and CPPIB has been an early and consistent investor in its funds. 

Ontario Teachers started investing in Asia via a fund-of-funds in the 1980s. It opened a Hong Kong office in 2013 and still mostly puts its $2.5 billion in Asia to work via the pooled funds of just six managers. However, its co-investment and direct investment activities are ramping up.

“We expect to co-underwrite the deals together with [GPs],” said Ouyang. “Every day, every month we want to be in conversation with our GPs and look at co-investments together,” she said at the SuperReturn conference in Hong Kong.

Click on page two for analysis of regulatory scrutiny of coinvestments 

Risk of conflict

While the desire of powerful asset owners to gain co-investment tranches is understandable, it raises potential conflicts for the private equity firms working with them.

GPs typically charge a 2% management fee and 20% performance cost for pooled funds, but will often lower these costs for side co-investments and structured accounts, and sometimes keep such arrangements secret. 

In a sign the SEC is watching co-investment carefully it said on December 14 that it has fined India-foccused and well-connected private equity firm, New Silk Route Advisors, $275,000 for a conflict of interest in its co-investments. 

“We automatically go for the so-called co-investment,” said Kimihiro Fukuyama, deputy director general of state-owned Development Bank of Japan’s global equity investment department. “This is a big conflict in some senses but GPs have to figure out a way to handle this trend,” he added.

“If most LPs are paying two and twenty and say five are paying less then that is somewhat of a conflict,” said Unigestion’s Marchand.

The US Securities and Exchange Commission (SEC) has said it is increasing its scrutiny of this so-called world of “shadow capital” to make sure the process of allocating co-investment opportunities is transparent and fair to all investors, whose end clients include pensioners, foundations and universities.

For GPs, being able to call on their LPs does give them exponentially more firepower to do deals and means they don’t have to share tactics and industry knowledge with direct rivals.

“I think this is part of the evolution of the industry to have closer relationships between GPs and LPs,” said Jean Eric Salata, the CEO and founding partner at Baring Private Equity Asia.

“It helps us do much larger transactions than we could normally do on our own, so we are actively looking for opportunities to work with our LPs on co-investments.”


Click for full view

Too much of a good thing

One potential danger of pursuing co-investing: over-commitments.

In order to gain access to co-investment opportunities, LPs risk having to place too much money into pooled funds.

This is a danger because private equity funds are an illiquid investment tool, and asset owners have no easy way to regain assets in the event of difficulty.

 “Sometimes LPs should ask themselves whether an investment decision to invest in the fund is more driven by the annex business rather than the primary programme,” said Unigestion’s Marchand. 

Ontario Teachers offers an example. It has about $2 billion in outflows to pay pensions every year, yet its illiquid assets have grown to over 60% of its AUM. As a result its asset liability management is of paramount importance.

“For a pension this is a dangerous thing. We can’t really hit the 70% (level) given the monthly cash outflow that we have to dispense,” said Ouyang noting that in Asia asset liability management is even more crucial as capital markets are much more shallow. Ontario Teachers prefers co-investments versus deploying capital into pool funds to maintain control.

Another risk of co-investing is that too many parties end up dictating how a deal gets done. Some LPs told AsianInvestor they only invest in a fund after conducting extensive due diligence on the GP. That work is moot if other LPs negotiate rights to interfere in deal-making or gain board seats at the portfolio companies.

Two thirds of LPs believe the growth in shadow capital (LPs’ non-fund-based private equity investments such as directs, co-investments and separate accounts) will hurt the returns of commingled private equity funds, according to Coller Capital’s 2016 survey of LPs.

To get around some of these concerns, Barings Private Equity is seeking to keep overall control of the investments it makes. “We set [investments] up so that we are still the only GP, the co-investors come into a new vehicle as LPs that we control – that keeps things straightforward,” said Baring Private Equity Asia’s Salata.

Yet there are many benefits for the lucky few that secure a sought-after co-investment deal – some not immediately obvious.

“One big reason pension funds are asking me for co-investments is that there is greater transparency… more people want to watch the investee company as ESG (environmental, social and governance) and similar matters are more important these days,” said  Fukuyama of the Development Bank of Japan.

It also helps improve the day job.

“We find it has been an extremely helpful way for us to get to know the GP, because we are working with the team and understanding their investment process,” said Melissa Kang, an executive director at Morgan Stanley Alternative Investment Partners. “When we do that we tend to choose better in the primary programme.”

This article has been corrected to show Gloria Song did not join CPPIB directly from KKR

¬ Haymarket Media Limited. All rights reserved.
Share our publication on social media
Share our publication on social media