Private equity: LPs set to play a new tune
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Private equity: LPs set to play a new tune

As direct and co-investment continues to grow, private equity firms must brace themselves for a fundamental change in their limited partner relationships.


Management consultants Bain & Co say 45% of limited partners (LPs) in private equity funds globally currently gain just 0% to 9% of their exposure to the asset class via co-investment or direct investment – otherwise known as shadow capital. 

However, within five years, it is expected that 40% of LPs will source 10% to 24% of their exposure in this way, with another 25% anticipating 25% to 49% of their exposure will be through co-investment or direct investment. That is a lot of money. And it is a lot of money that will no longer be funnelled through private equity firms. 

M&A database PitchBook calculates $111 billion was invested directly by LPs via 64 deals in 2007 but this had dropped to $9 billion via 48 deals by 2009. By 2013 direct investment had recovered to $37 billion via 141 deals and by August 31 this year, $27 billion had been invested through 75 deals in 2015 already.

Although shadow capital is attracting a lot of attention, it is still dominated by a small number of investors – hardly surprising given the investment and manpower required to assess the risks involved. 

The likes of the Canada Pension Plan Investment Board (CPPIB) and the Ontario Teacher’s Pension Plan (OTPP) dominate the field. Indeed, CPPIB had undertaken 140 direct investments between 2006 and August 2015, which account for 16% of total global direct investment in that period. 

But more and more sovereign wealth funds, family offices, endowments and charities are opting to go it alone in this asset class rather than invest via a private equity fund. For example, the UK’s largest charity, the £18 billion Wellcome Trust, had £4.4 billion exposure to private equity in September 2014, of which £733 million, or 16.5%, was via direct investment. This was up from £515 million in 2010.

Much shadow capital activity has been focused on start-up venture capital. In December 2014, Singapore’s GIC participated in a $1 billion funding round by Chinese smartphone maker Xiaomi Corp, which valued the firm at $45 billion. In the same month Qatar’s QIA participated in a $1.2 billion funding round for mobile ride-sharing firm Uber. 

It is not only sovereign wealth funds that have been active recently. For example, Harvard Management Company participated in early fundraising for shared office space start up WeWork, which was valued at $5 billion in December last year. 

Conventional wisdom has been that direct and co-investment is good for both LPs and GPs: GPs can offer co-investment and separate accounts to attract larger commitments from LPs and deepen the relationship while LPs have far greater control over where their money is invested. But as competition for assets in this market gets ever more intense, nerves at PE firms are starting to fray. 

Shadow capital represents real competition for assets, the last thing that sponsors need in a market where it is already so difficult to put money to work. Perhaps most worryingly, as LPs gain in confidence they are winding down exposure to PE funds themselves to boost their allocation to direct and co-investment. 

In September, GIC sold a $1 billion portfolio of private equity fund stakes to French alternative asset manager Ardian, which had been negotiating to purchase $1.5 billion of similar assets from the Abu Dhabi Investment Council. Indeed, in April the Ontario Municipal Employees Retirement System (OMERS) declared that it planned to wind down its private equity investment fund programme completely within four years to allocate to the sector directly. 

If this strategy takes hold at many of the large LPs on which private equity firms have relied for large allocations over the years, it will be very bad news indeed.

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