Brian Lee, Garrett Black September 18, 2015
Limited partners’ role in the traditional scheme of private equity and venture capital isn’t as passive as it used to be. Direct and co-investment by LPs—dubbed “shadow capital” by Bain Capital, among others—has boomed as of late, driven in main by a cadre of experienced firms.
There are plenty of factors contributing to this rise. By directly investing or co-investing alongside experienced general partners, LPs can boost returns as well as retain greater control of their capital. LP personnel can also garner experience in particular sectors, types of investments, etc.
That last is something that critics of the increase in shadow capital investment seize upon, with some justification. Many GPs have contended that many LPs do not possess teams with enough experience and/or incentives to justify carrying out investments on their own. This is undoubtedly true, though a skeptic could point out that the rise of shadow capital could act as a disintermediating factor, reducing the role of GPs.
In the grand scheme of things, however, that is unlikely given the proportion of direct LP investments to overall PE & VC investment. That opinion also overlooks how LP-GP relationships have evolved in recent years. The option to co-invest has been appearing more frequently as a way for GPs to entice LP contributions, with fee discounts as part of the package. Plus, as calls for greater transparency into fee structures grow ever more strident—especially in the wake ofthe CalPERS’ carried interest debacle—LPs may well push for such increased involvement in investing as a way to better track performance. Many GPs go along with this approach in order to draw upon further LP resources—Blackstone and other fund managers have been making overtures along those lines already.
Performance of LP direct and co-investments can vary, however, although LPs with plenty of experience in direct investment, such as Canada Pension Plan Investment Board or Ontario Teacher’s Pension Plan, can boast of success. The thing is, LPs with such investment credentials aren’t exactly common. Both those public pension funds are outliers, not the norm, prime examples of the cadre of experienced LPs driving the overall direct investment trend. CPPIB, for example, has carried out no less than 140 direct investments between the start of 2006 and the end of August 2015, a 16% of all direct investments in that timeframe worldwide.
Direct investment isn’t restricted mainly to PE, although the most experienced LP investors tend to carry out deals typical of buyout shops and PE accounts for the vast majority of capital invested, understandably.
There has been a considerable increase in VC direct investment by LPs, thanks in part to increased activity by the Wellcome Trust and the Bill and Melinda Gates Foundation. Those institutions are somewhat in a category of their own when it comes to funding startups directly; they do qualify as limited partners according to PitchBook methodology as they back funds of other investors, but also have historically acted directly more often than your typical LP. That being said, even taking their activity into account, direct VC investment by LPs has definitely ramped up over the past few years.
Late stage deals are responsible for most of the increase in venture capital invested as of late—a sign of how alluring the venture capital boom has been to investors across the board. Take Harvard Management Company’s participation in WeWork’s $355 million Series D round in December 2014, for example. Getting in on the unicorn stampede, even if it’s at a late stage, draws even university endowments to participate directly. How much longer that persists will likely depend on the overall venture industry’s prospects, which still appear strong if a bit shaky as of late given recent market volatility.
It’s easy to see, then, why such activity is inspiring other LPs to emulate experienced LP investors like CPPIB, OMERS and others. Hurdles still remain, as pulling off direct investments does require developing dedicated teams for deal sourcing, management, due diligence and the like, but as direct investment by LPs show no signs of slowing down, more LPs may begin developing their own investment capabilities. For now, co-investing or co-sponsorship seems a safer route on the PE side in particular.
But regardless of the cautious approach, the fact remains LP direct investing is increasingly popular. With calls for transparency around fee structures in the PE industry growing ever more strident—especially in light of the CalPERS’ carried interest debacle—it’s clear a shift in the PE industry is underway. LPs aren’t abandoning traditional commitments by any means, but they are looking for a more active role in the asset class, whether by calling for reform or looking for more exposure via direct and co-investment.
You can delve into LP direct investments through the PitchBook Platform: click here.