Private equity and investors: Where is this relationship going?

Private equity and investors: Where is this relationship going?

The harsher realities of raising new funds and the downward pressure on returns have given general partners and limited partners powerful incentives to try new approaches.

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Private equity and investors: Where is this relationship going?

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Across the booms and busts of private equity’s long and dynamic history, the basic terms by which general partners (GPs) and limited partners (LPs) do business have remained remarkably stable. But as we discuss in Bain & Company’s Global Private Equity Report 2013, the harsher realities of raising new funds and the downward pressure on returns have given both GPs and LPs powerful incentives to try new things. The search is bringing forth intriguing variations in the PE business model.

GPs sell LPs a stake in their firm. While not a new phenomenon, the past year saw several instances of GPs selling a stake in their firm to an LP and move toward a more permanent capital base. Last September, for example, CVC Capital Partners, the UK-based global private equity firm, sold a 10% stake in itself to three deep-pocketed sovereign wealth funds, including the Government of Singapore Investment Corporation and the Kuwait Investment Authority. For LPs, the attraction of becoming a minority owner of a PE firm is the opportunity to participate in the same economic benefits the GP enjoys, including a share of the fee flow it receives on the funds it manages and a proportionate slice of the carry it earns.

Separate LP accounts. GPs have hit upon a promising way to win big, multiyear commitments from larger LPs by setting up side accounts they will manage, often for a reduced fee. In the biggest such deals last year, KKR and Apollo Global Management each landed $3 billion in commitments from Teacher Retirement System of Texas (TRS). The GPs retain wide latitude in terms of the investments they can pursue. In exchange, the TRS special accounts will pay substantially lower fees than a typical fund LP, and they will be offered a first opportunity to participate on many deals. The capital returned to the accounts can be reinvested at TRS’s discretion, with the understanding that it will be committed for longer than the typical five- to seven-year time frame. In addition to more favorable economics, special accounts enable LPs to make a significant commitment to a set of investment strategies they find compelling and also gain greater access to the GP specialists they work with. The clear upside for GPs, of course, is the opportunity to land larger, more permanent capital commitments.

Buying out a GP’s assets. Perhaps 2012’s most provocative new collaboration has been an outright purchase of an entire fund’s assets led primarily by one LP. The LP in this instance was the Canadian Pension Plan Investment Board (CPPIB), and the fund in question was Behrman Capital III LP, an 11-year-old fund originally valued at $1.2 billion that was created by Behrman Capital, a New York-based buyout firm. Working with Behrman and other LPs, CPPIB committed up to $654 million to form a new $1 billion, six-year fund called Behrman Capital PEP LP. About 75% of the new fund’s capital was tendered to buy five businesses still held in Behrman Capital III LP; the balance could be used to make add-on acquisitions or new investments. By accepting the option to sell, the legacy LPs were able to cash out of their aging asset. The new LPs in Behrman Capital PEP were able to buy five businesses at what they believed to be attractive valuations, while at the same time investing in a fund with a lower fee structure. The arrangement gave Behrman Capital a new lease on life and reset the clock on the portfolio investments, enabling Behrman to patiently nurture the portfolio companies for solid gains.

Nontraditional fund models. Some newer GPs were among the innovators of novel approaches for winning LP commitments in 2012. One such newcomer was Altas Partners, which aims to break through the fund-raising clutter that most new firms face by offering LPs a unique value proposition it calls “core private equity investing.” Altas plans to target companies with a hard-to-replicate business model and that offer the potential for a longer holding period than traditional private equity. Relying on less leverage to finance deals and charging more modest fees than are standard in the industry, the LPs that commit capital to the new fund stand to earn net returns that are consistent with traditional private equity investing but with less risk.

Direct-sponsorship programs. Direct investing is nothing new for LPs. However, interest in expanding direct-sponsorship programs has recently taken on a new life. For example, Teachers’ Private Capital, the private equity arm of Ontario Teachers’ Pension Plan, has completed 13 direct investments since 2010, including six during the past year. Early analysis suggests that direct programs do have the potential to generate attractive returns. But even for large LPs, direct investing is a big leap from conventional fund investing or active co-investing. To establish a credible program requires end-to-end investment capabilities that take a lot of time and money to build.

The ultimate success of each of these arrangements will not be known for years, but one thing is already clear: More experimentation is on the way.

Written by Hugh MacArthur, Graham Elton, Bill Halloran and Suvir Varma, leaders of Bain & Company’s Private Equity Group.


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