This article originally appeared on Forbes.com.
As private equity general partners (GPs) and limited partners (LPs) contemplate moves for the coming year, persistently high asset prices are playing a larger role in their thinking.
The accretion of dry powder (committed yet undeployed capital) to new record levels is not expected to slow anytime soon. This swelling pool of capital is chasing a set of deal opportunities that has not expanded as rapidly. Indeed, since 2012, the count of global buyout deals decreased at a rate of 9% annually, while deal value rose at only a 6% compound annual growth rate.
The ascent of shadow capital, in both scale and scope, has exacerbated the situation. Forms of shadow capital range from separate accounts to coinvestment and cosponsorship to solo direct investments. Precise totals of investments in these four categories don’t exist, but Bain & Company, in its newly released Global Private Equity Report 2017, estimates that coinvestment (the largest form of shadow capital) represents 10% to 12% of traditional fund-raising and that shadow capital in all its forms combined could be as much as 15% to 20%. What’s clear is that shadow capital is large, growing and here to stay.
Shadow capital can offer substantial benefits to LPs, including lower fees and carried interest, and greater control over the timing of investments and exposure to industries or geographies. But shadow capital pours more fuel on the fire by further intensifying competition for assets. That competition, combined with the lower cost of shadow equity and direct LPs’ traditional preference for middle-of-the-fairway deals—companies with strong management, healthy financials and operating in attractive industries—has been driving down returns of such deals.
As a result, GPs who aspire to generate the strong returns that a “2-and-20” model demands will have to take on more risk or get more creative in putting money to work. The standard formula for GPs cannot accommodate the prices paid in the middle of the fairway. PE funds are getting pushed into the rough and the sand traps, where the higher-risk deals live. Whether it is underwriting more growth or tackling tricky turnarounds, GPs need to sharpen their pencils to determine what risks they are willing to underwrite and, at the same time, build stronger capabilities to manage that risk.
Some PE firms have gone off the beaten path to close high-potential deals. Silver Lake teamed up with Michael Dell, for instance, to piece together an offer for Dell that included cash and equity contributed by Mr. Dell, equity from Silver Lake’s buyout fund and coinvestments, along with rollover and newly issued debt.
Creative arrangements might entail partnering more with corporate buyers to find companies that suit the needs of both parties. Having a strategic coinvestor provides a built-in exit strategy when the timing is right. For example, GI Partners teamed up with Allscripts Healthcare Solutions to buy healthcare software and services provider Netsmart Technologies from Genstar Capital for $950 million. Allscripts merged its smaller rival business, Allscripts Homecare, into the joint venture.
Deal structuring can get more creative as well, for instance, by offering sellers the opportunity to roll over some of their equity into the transaction. HGGC, a US middle-market PE firm, requires all sellers—whether large sponsors, a founder or a management team—to reinvest. “They are less focused on the highest price because they’re not leaving,” CEO Rich Lawson told PE Hub. This has helped HGGC to pay lower deal multiples, on average, than other firms.
Establishing a joint venture rather than making an outright purchase of an asset holds out another creative approach to deal making. Tenet Healthcare paid $425 million to buy 50.1% of United Surgical Partners, a portfolio company of Welsh, Carson, Anderson & Stowe, in a joint venture. The deal also gave Tenet a path to full ownership over five years through a put/call structure.
The days of earning attractive returns by simply buying and holding middle-of-the-fairway deals are over, as investors bid down the returns for these classically good, safe assets. Forward-looking GPs have already begun to examine their appetite for greater risk and their ability to deliver on that.
Hugh MacArthur, Graham Elton, Daniel Haas and Suvir Varma are leaders of Bain & Company’s Private Equity practice.