Co-Investment in Private Equity Carries ‘Substantial Risk’

(April 1, 2014) — Investors tempted by co-investment deals in private equity assets should watch out for concentration risk and poor returns, according to Altius Associates.

Co-investment deals see investors buying a direct stake in a company alongside a private equity fund. They have become popular with institutional investors in recent years, due to the advantages they offer, including: avoiding annual management fees; capturing the full upside by not paying carry; the mitigation of the ‘J’ curve phenomena; immediate deployment of capital; and control of investment/sector exposure.

For those selling the co-investment deals, the partnerships provide a way for buyout firms to raise capital. Firms including BC Partners, EQT Partners, Cinven, and Permira have all offered fee discounts to investors that take part in a first close.

Some of the world’s best known private equity investors—including PGGM, F&C Investments, Abu Dhabi Investment Authority, Partners Group, AlpInvest Partners, Pantheon, and Hermes GPE—are known advocates of co-investments.

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And last year, the London Pensions Fund Authority completed its first ever private equity co-investment, teaming up with Swiss private equity manager Adveq to buy a stake in postal company Secured Mail.

However, a study carried out by Altius that analysed 886 realised US buyout and growth investments—ranging from 1979 to 2010—showed that for a co-investment portfolio made up of 10 assets there was a substantial probability that the entire portfolio would generate an internal rate of return (IRR) of less than 0%.

Even with a 20-company co-investment portfolio, it was possible to lose significant capital as measured by either IRR or multiples.

Author of the study and Head of Americas Investment at Altius Dr William Charlton said: “As with most aspects of private equity, selectivity is one of the most important components of driving returns for investors. But even with good choices, co-investment portfolios may be subject to additional risk due to the impact, positively or negatively, of a small number of transactions in the portfolio.”

Altius’s research revealed two inherent risks. For general partners (who retain management control, share the right to use partnership property, share the profits of the partnered firm, and have joint liability for the debts of the partnership), there may be an incentive to keep the highest expected return investments wholly within the fund structure.

But adverse selection may occur when funds offer co-investment in deals that exceed fund capacity, which may put the fund manager in a market segment for which past returns are not representative and are more uncertain.

For limited partnerships, (where partners have limited liability, no management authority and are only liable on debts incurred by the firm to the extent of their registered investment,) Altius identified substantial concentration risk. Limited partners tend to only invest in a subset of a manager’s portfolio, leading to an over-concentration of investment in a small number of companies, it said.

“While there may be important strategic reasons for institutional investors to establish or expand co-investment programmes, care should be exercised to avoid the issues of intentional or unintentional adverse selection,” Charlton continued.

“Even if adverse selection can be avoided, there should be an appreciation for the nature of the risk inherent in a portfolio that contains a small number of risky investments that are likely to be highly correlated.”

Despite the risks, it seems investors’ appetite for co-investment private equity deals is on the rise. Data from Preqin released last month showed half of the private equity investors it questioned were planning to increase their exposure to this type of deal in 2014.

Today, 40% of investors Preqin spoke to are actively co-investing, while 37% are co-investing on an opportunistic basis. Another 16% are considering co-investing in the future.

However, in direct contrast to Altius’ expectations, 77% of investors expected their co-investments to outperform their fund investments by 2.6% or more, while no investors expect them to perform the same or worse.

(April 1, 2014) – The bankrupt City of Detroit has put forward an updated plan for settling with creditors, preserving key assets, and returning to solvency.

The plan stipulates aggressive liability cuts to the city’s two major public retirement systems, despite an $816 million infusion of outside funding. Retiree medical and death benefits are treated as any other outstanding debt, while pensions are afforded higher priority.

Members may vote on whether or not to accept the city’s plan once it has been finalized in coming weeks, according to municipal documents.

Retirees belonging to the police and fire system who accept the proposal would have their pensions cut by 6%, while those rejecting the plan face 14% benefit reductions. For members of the General Retirement System, a "yes" vote accepts lowering payouts by 26%; a "no" leads to a 34% benefit haircut.

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Regardless of vote or pension system, the plan drops cost of living adjustments from benefit calculations.

In total, the proposal allocates $1.59 billion for police and fire pension claims and $2.3 billion for the General Retirement System. Until 2023, both systems’ assumed rate of return on investment would be capped at 6.25%.

These reforms reflect deeper benefit cuts than those laid out in the previous scheme, which was released in late February.

The updated restructuring plan protects the collection of the Detroit Institute of Art, which was potentially up for liquidation during earlier negotiations. In January, a group of non-profits including the Detroit-based Kresge Foundation and the Ford Foundation committed $330 million to help save the art works.

Under this latest plan, to preserve the collection the state of Michigan will nearly match the foundations’ contribution—since increased to $336 million. The museum itself has also committed $100 million to the effort. If the proposed deal goes through, the foundations, state, and museum will purchase all of the institute’s assets, which will then be placed “in a perpetual charitable trust for the benefit of the people of the city and state.”

The city’s 235-page plan addresses other potential sources of revenue, including new bond issuances, and outstanding debts.

Another point of progress revealed in the documents relates to the $288 million owed to UBS and Merrill Lynch for pension interest rate swaps. The financial firms have agreed to settle with the city for $85 million, and in turn would relinquish their claim on Detroit’s casino tax revenue.

"The city continues to make progress with its creditors and retirees and hopes to reach agreement in the near term on a number of outstanding issues," said Kevyn Orr, Detroit’s emergency manager, at the plan’s release.

"We believe that the plan we have proposed, and continue to refine, is feasible and allows the city to reduce its staggering $18 billion in debt and live within its means,” Orr continued, noting that the proposal “puts the focus back on providing essential public services to the city's nearly 700,000 residents."