When investors look at public markets today, many see high current valuations, low expected returns and a likelihood of increased volatility. Against this backdrop, it’s little surprise that more than a few are increasing their focus on private markets, and on private equity specifically. Their interest is amplified by a shift in the public-private balance of company ownership. With more companies going private or staying private for longer, allocators who want to be invested in growth over the next decade have even more reason to consider private equity.
There are several ways for institutional investors to access private equity today: the traditional route of GP/LP structures; co-investments alongside those structures; secondary markets; and direct, flexible-hold strategies.
This II interview with Lynn Baranski, Managing Director at BlackRock Private Equity Partners, focuses on the opportunities and dynamics in today’s co-investment market, and is one of a three-part series on creating persistent alpha in private equity.
Where are you finding value in private equity co-investments right now?
What we really focus on is the general partner’s angle on the transaction — how are they going to add value and what’s their value-creation plan? We then spend a lot of time in our due diligence focused on how best to stress test the assumptions that underlie the value-creation plan. In today’s market, this would certainly include understanding how the company or industry performed in different market cycles.
On a forward-looking basis, understanding how a company may perform in a potential recession and what levers management can use to weather a downturn is critical as we stress test business models. With these questions in mind, where we see value right now is very asset-specific, but there are some common themes that catch our eye.
What’s an example of such a theme?
Corporate carve-outs are interesting — there’s always a steady supply of these transactions as companies sharpen their focus on core businesses and adjust long-term strategies to drive value. We really like orphaned subsidiaries. Typically, the best management teams or executives don’t want to work in a non-core subsidiary of a larger company. Without that leadership, orphaned subsidiaries tend to lack the strategic vision and investment they need to grow — they’re often capital-deprived. So, in a corporate carve-out, while there may be cost-cutting in some areas, there can also be investment in growth-drivers. GPs often add best-in-class management, with an incentive structure that motivates them to align with the value-creation plan. Often their investment back into the company drives value creation in the form of new product development or expansion into additional geographies.
Any other themes you like?
We will spend time on buy-and-build strategies, which can be effective at creating value even when purchase prices are relatively high. We’ll look at a company that we think is really best-in-class in a fragmented industry. We’re willing to pay market price and maybe even above for a healthy core platform asset. Then we can execute a roll-up or tuck-in acquisition strategy to accelerate top-line growth and drive operational synergies. A recent example of this that investors might find surprising is a traditional travel agency that we acquired. It’s focused on highly curated packages for affluent travelers — think African safaris — that no one is going to book on a discount travel website. We acquired that company at about $70 million in EBITDA and made some highly accretive follow-on acquisitions that have increased EBITDA to $125 million.
It’s also worth noting that in today’s highly priced market we look across the capital stack to find the best risk-adjusted returns. In that context, going back to 2018 we started seeing opportunities in preferred securities, where a company needs an additional layer of junior debt or preferred equity. These deals allow us to target high-teens return profiles, with multiple layers of equity buffers. Finally, we are always looking for any business that is disrupting a traditional industry.
What are the supply and demand dynamics in co-investments today?
We’re hearing from GPs that every limited partner that comes through the door is asking to see their co-investments. LPs have to be careful on resourcing and due diligence in order to effectively build and manage the risk of a co-investment portfolio. But if you can do it well or hire a team to do it well for you, you’re lowering your fee load while adding potential alpha into a portfolio through asset selection and diversification.
From a supply perspective, we are seeing healthy supply as GPs rarely will partner with other GPs like they used to do. Rather, they are turning to their LPs for additional capital when needed. As a result, we are being brought into transactions earlier and earlier, usually during the bidding stage, because we are willing to provide the resources and team to move alongside the general partners as they are doing their due diligence. Committing the resources and time in the early stages of a transaction gives us more time to complete our due diligence, and it often allows us to lock in allocations. We’re starting to see larger and larger transactions as well, which have provided additional co-investment opportunities for LPs.
How do you manage risk in individual deals and in a portfolio of co-investments?
We view portfolio construction as a key component of risk management. Vintage year is very important to portfolio diversification. We’ve seen some investors make the mistake of suddenly deciding they want to be in private equity and then deploying way too much money in a single not-so-great vintage year. We believe in building a private equity portfolio over a four- to five-year period, and that pacing is super important in portfolio construction and risk management.
We also look to diversify the portfolio by geography, industry, and general partner, and within industries we break that down by the stage of investment. If it’s a global program, we methodically track geographic diversification.
As we think about individual companies, we try to size our co-investments based on their risk-adjusted returns. Generally, our position sizing would range anywhere between 3% and 7% of a portfolio, with the 3% allocations being companies we perceive to have higher risk, but also maybe higher return potential.
A 7% company would tend to have an asymmetric risk-return profile. Typically, these companies are market leaders, and we can effectively diligence their competitive framework. They often have high cash flow conversion, and they may have high recurring revenues. As important, we like deals that have multiple drivers of value creation, so it’s possible to realize private equity returns even if companies don’t fully achieve any one component of their value-creation plan.
For the last several years we’ve also focused more on the qualitative aspects of risk management — all the environmental, social and governance (ESG) factors and their impact on a company and its reputation, for example.
How do you see the co-investing market evolving in the future?
We’ll continue to see the market evolving because LPs can provide unique solutions to the private markets. Fifteen years ago, LPs were not as critical to getting a deal closed. Today, when my team writes equity commitment letters to help provide certainty of financing for a take-private, we are comfortable working alongside the GPs — often with incomplete information. We have a dynamic investment approval process that can handle tight timelines. And we will take board or observer seats and, at times, have voting rights.
We also see more fundless-sponsor transactions. If we know general partners that have a solid track record over time, and a network that allows them to find unique deals — maybe they’re trying to raise a fund, maybe they’ve left their organization and don’t have capital yet — we have found ways to provide them with capital to execute transactions. We’re willing to do the work because typically those deals are very proprietary, often have a unique angle, and we are able to buy them at a discount to where most of the market is trading.
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