Why LPs should be cautious about co-investing

The history of investors trying to make co-investments with private equity firms or even go it alone is strewn with casualties.

Big asset owners in Asia may want do more co-investments and direct deals in private equity, but history is replete with cautionary tales of investors who tried to build up internal capabilities to do just that.

Over time, there have been cycles where limited partners [LPs] have tried to staff up and do deals directly and in general it’s been hard because they have structural disadvantages,” said one senior private equity professional, who did not want to critique investors in the asset class on the record.

Private equity firms focus on making deals, whereas small PE arms of pension funds are part of a bigger operation and may be slowed down by bureaucracy and starved of resources. “Even the biggest ones don’t have the staff and size across the globe of the large private equity firms,” the professional said.

Additionally, asset owners that build their own direct investment teams then have to pay competitive compensation to keep talent from joining private equity firms.

The mean annual compensation for the managing partner of a PE firm in Asia is $812,450, plus carried interest of $6.6 million on a fund size above $2 billion, according to a 2016 survey by search firm Heidrick & Struggles.

While the desire of LPs to poach investment professionals from general partners in the region has helped boost compensation levels – witness Canada Pension Plan Investment Board (CCPIB) hiring Gloria Song, previously of KKR, in October – that’s still a fair amount more than a typical fund manager in a public pension scheme could expect to receive, said the headhunting firm. 

While an institutional fund manager might find the rewards of conducting direct or co-investing to be tempting, they come at a cost – namely, job security. 

“There are better economics that exist on the co-investment side,” said Malinder Saluja, a partner at family office Quilvest, responsible for about $1 billion of capital focused on fund and co-investments, at a recent conference in Hong Kong. “The likelihood of losing your job is higher too." 

Singapore’s sovereign wealth funds, GIC and Temasek, have long made direct investments across the region, but have also nurtured their relationships with PE fund managers by investing in their funds and co-investing alongside them, said industry professionals.

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

Harvard Management, has come in for harsh criticism from professors and alumni as a for-profit enity in a non-profit university for hiring highly paid money managers.

“You have to be a very enlightened institution when you represent teachers, whose salaries are $50,000 to $60,000 a year, to pay professionals millions of dollars in compensation – even if they are making billions of dollars for the fund,” said the senior PE professional. “It can be done, but it is the exception rather than the rule.”

President Jack Meyer ran the $37.6 billion university endowment fund from 1990 to 2005 and set up an internal full-service investment team to compete with the best on Wall Street. He eventually left to form his own hedge fund, mimicking at least 12 of the top-performing managers he’d employed.

CEOs at the US’s largest endowment, such as Jane Mendillo, continued his strategy of direct investing which led to blowups – such as the firesale of Romanian forestry after a bribery scandal. After years of sub-par returns for its private equity deals and rapid turnover at the top, Harvard Management is moving towards hiring outside managers to manage its money. 

Qatar Investment Authority (QIA) is another example of a fund that has tried its hand at direct investing.

It struggled to make its direct investment strategy pay off after buying into assets as diverse as Credit Suisse, UK airport Heathrow and jewellery company Tiffany. Kenneth Shen, head of private equity, shifted QIA's focus to Asian deals in 2007 and moved to Malaysian state fund Khazanah in 2011.

“He came at it with a lot of fire and brimstone,” said a person who had meetings with him to discuss his investment plans while he was at QIA. “He really thought he could create a Blackstone within a few weeks.”

Another person that spoke to him frequently at the height of his investing days for QIA said he complained that business corruption in Qatar weighed on the returns of the fund.

It was not the only sovereign to push into direct investments. The Investment Corporation of Dubai, the main investment arm of the Dubai government, purchased in 2013 the Atlantis, a hotel on an artificial island on the Dubai coast, which it still owns.

¬ Haymarket Media Limited. All rights reserved.
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