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 The Risk of Adverse Selection in Co-­‐investing Private Equity Performance David Snow, Privcap: Today, we are joined by Andrea Auerbach of Cambridge Associates, Maurice Gordon of Guardian Life, and Luca Salvato of Coller Capital. Welcome to Privcap. Thanks for being here. Unison: Thank you for having us. Thanks. Great being here. Snow: We are talking about private equity performance. There is a very hot style of investing that is increasingly gaining popularity among LPs, which is co-­‐investing. We are going to be drawing from research that Cambridge Associates has done with Andrea Auerbach’s team. But why don’t we start off with understanding what is behind the increasing popularity of co-­‐investment among limited partners? Luca, you could walk us through this trend? Luca Salvato, Coller Capital: I would say it’s probably the most common request you get from an LP, certainly, as a manager of funds. Now, the intention and the reasons that you’ve seen LPs increase at least their attention to it is one from a desire to deploy capital. In their minds, it is a way they can often mitigate some of the fees and structures, so they see it as a cost reduction from an investment perspective. More importantly, I think a large objective for many of the LPs is a way to boost returns, because it’s a way they can ultimately outsize their returns from the fund investments. That’s either through selection or through managing certain GP relationships and, in essence, being more concentrated in the way they put their bets to work. Snow: Maurice, you are investing capital on behalf of Guardian Life into private equity. What is your view on the popularity of co-­‐
investment? Maurice Gordon, Guardian Life: My background is co-­‐investing. I spent several years doing co-­‐
investing based on the State of Michigan deal flow that we had a separate account for. But it’s very popular. We love it. Our Snow: number-­‐one reason is for building relationships. We really want to do a deep dive to understand our general partners better and build a stronger relationship with them so that we can make better primary fund decisions as well as co-­‐investment decisions. Andrea, you recently did a study on co-­‐investment performance. Why was the study necessary? Andrea Auerbach, Cambridge Associates: It’s interesting, because co-­‐investing as an activity has been around since the very first private equity fund, right? It’s definitely having a moment in the sun right now. I think there are a couple of industry dynamics speaking to that, which Luca mentioned as well as Maurice, [including] a desire to increase the return potential of a program. Co-­‐investments, selected and invested properly, are definitely a way to boost return. Also, you can boost return through lower fees, all else being held equal. Then, it truly is a way to deepen your knowledge of a specific manager. So, I think there’s been a rise in the availability of co-­‐invest. Another dynamic that’s feeding into the moment it’s having right now is [that] we all remember the global financial crisis and some of the activities that precipitated that. I’m not saying they caused it, but there was a lot of consortium investing and...a lot of GPs buddying up to do a deal. LPs were left wondering, “Why wasn’t I asked? I’ve got money. I’ve got capital. I’m capable of being an equity partner with you.” Right now, GPs are having knowledge that they would rather have a stronger LP relationship than give away some of the deal to another GP. So, there’s a bit of a lesson learned that is playing through the market today. Snow: There are risks to co-­‐investing, one of which is adverse selection. Luca, can you summarize what that means in the context of co-­‐
investment? Salvato: The adverse selection point is an interesting one. There are so many dynamics that play into the flow of co-­‐investments and the peaks and troughs you see in it. I think there is a systemic demand now amongst the LPs that are really driving a desire to see an increased amount of co-­‐investment. At the very large end, you may even see some LPs that almost dictated the condition of their investment. You’re seeing GPs raise smaller funds but wishing to stay in the same investments they were doing in terms of size or equity Snow: Auerbach: Snow: Auerbach: Gordon: checks. That means they can’t do it out of their fund, so they need to bring in co-­‐investors. And LPs like that. But the reality is that the adverse selection point in is a market and, certainly in frothy markets, you see the volume of co-­‐
investments go up. And if you look at the returns—and Andrea’s report goes into this in some detail—that is ironically probably the worst time to be investing in co-­‐investments. So, any time you see a GP either doing deals where they’re stretching from an investment-­‐size perspective to what their norms and past experiences are, or even strategy shifts in areas where they haven’t invested before, that’s where you probably have to tread with a bit of caution. And that really comes down to the experience you have as an LP in terms of being able to sift through co-­‐investments. I guess a key question for an LP is, when co-­‐investing, do you sit back and assess each new opportunity that comes your way and pick and choose based on what you believe is a strong opportunity? Andrea, you...compared LPs who just went with the fund itself versus those that also invest with the same GPs off to the side as co-­‐investors. We’re taking a look at the chart now, but what did you discover when comparing those two groups? We took a number of funds that spawned co-­‐investments and the overall result of simply doing the fund investment alone was about a 1.5x net, I may add, to this table. However, then we went and took a look at the co-­‐investment deals that came out of those funds and, overall, those co-­‐investments delivered a 1.3 gross. So, it’s going to be even lower on a net basis. It will be even lower on a net basis. Then, if you get into the element of—if I just did every co-­‐investment that came along, that would have been my net-­‐result gross. If I had the ability to pick only the winners and do better, that was slightly less than half the time and slightly less than half the time, did the investments actually outperform the sponsor fund? For those co-­‐investing, this analysis pointed out to us trying to out-­‐invest the investor is a proceed-­‐with-­‐caution moment. Especially if you don’t have the right resources or policies in place to know what you’re looking at. If I might add, I really think there is adverse selection, but part of the nuance of that is you don’t get it on purpose. I don’t think a GP is saying, “I’m giving you a bad deal.” But, they sure can tell you they know if they’re giving you a risky deal. I mean, I’ve been on the phone before and they said, “Look, Maurice. This is a good deal, but it may be outside of your risk zone,” because it was really a bit outside of their risk zone. So, it gets back to your strategy on which co-­‐investments you want to do.