Branching out – LPs warn of potential pitfalls

Earlier this month, unquote" spoke to Ardian managing partner Dominique Gaillard about the firm's first year as an independent outfit since its spinout from Axa. Ardian is an example of a GP with its fingers firmly in many pies, having raised growth capital, buyout, mezzanine and secondaries funds. Most notably, the firm raised $10bn for its sixth-generation secondaries fund-of-funds in April, the largest sum ever raised for this type of vehicle.

However, not all LPs are comfortable with firms that begin to broaden their horizons, for fear of a fund's strategy becoming unclear or a team becoming too thinly stretched from workload. Private equity firms that have diversified should make a sharp distinction between the teams managing the different investment strategy programmes and the investment committees overseeing them, says Graeme Gunn, a partner at SL Capital Partners.

"For us, the issues are around clarity of strategy – ensuring the team are driving in one way," says Gunn. "Otherwise it is hard for us as an investor to see where the true alignment lies. When a group is trying to do multiple things out of one fund, or is launching multiple products with crossover in the teams, that's when we get nervous. It becomes more of an asset management game rather than a private equity game."

This issue – the need for separation of investment teams – could be the reason that, historically, the majority of diversified private equity firms have operated in the large-cap space, as they generally have the means and cash to hire an entire new team. However, the practice of diversifying has, in recent years, begun to trickle down into the mid-market.

In 2005, mid-cap player 3i established its separate infrastructure arm – though it had been investing in the space since the 1980s. The firm then established its debt management division in 2011 following the acquisition of Mizuho Investment Management. In its 2011 annual report, 3i stated the establishment of its debt line "reinforces that 3i is no longer solely a private equity business but rather a broader-based alternative asset manager and investor".

From fund manager to asset manager
However, this transition into "asset management" is one of the areas that have made some LPs wary. "As an LP, we can play in multiple segments of the market, but when you're on the ground as a GP, it can blur your investment strategy," says Gunn. "Some LPs are willing to back a firm on multiple funds because they're really backing a brand they trust. But we invest where private equity is a firm's sole business model, because they've got to make it successful or they won't raise the next fund – we like that survivor bias. We can diversify by strategy, geography, stage and size within that."

A main point of concern for LPs is the risk of conflict of interest, and the worry that a firm may use their various business lines to provide each layer of investment in a single deal. As Adveq CEO Sven Lidén points out, if a diversified private equity firm sources a deal where the company looks as though it will treble in value, then the opportunity to also invest mezzanine or senior debt – alongside equity – will be tempting.

"There are examples of groups – mostly banks – that tried to do that in the past where it has gone very badly due to the different agendas and inherent conflicts of interest, especially if something goes wrong with the deal," says Gunn. "Firms with a credit fund and a private equity fund should not and do not invest in the same asset."

Lidén agrees: "How can you represent all your clients if you are representing some who are invested in senior secured loans and some who are invested in equity? They will have completely opposite interests in what is going to happen in a difficult situation."

Some of these potential problems can be avoided with the correct procedures put in place, such as firm Chinese walls. But there are past cases that remain as a stark warning to others – namely the downfall of Royal Bank of Scotland, whose £1.1bn Special Opportunities Fund provided both mezzanine and equity alongside debt from RBS.

But there are some firms that have implemented a more secure strategy to execute deals by providing both equity and debt. For example, Total Capital Partners, a London-based firm focused on the small-cap market, has one syndicate of LPs that are invested across the board. This means the firm is not in danger of alienating one band of LPs to appease another if an investment begins to flounder. Of course, it also means LPs are twice as likely to get burnt should an investment fail, making confidence in the GP's abilities an essential component of the LP agreement.

Greener pastures
Given the trends at play in the post-crash market, the temptation to branch out is more tempting than ever though: with banks shying away from the market and a downturn in private equity dealflow, the move for many private equity firms into the debt market appears an obvious choice. "Client demand today is very much for current yield, which leads private equity managers to look at anything that provides current yield, like mezzanine or senior secured loans," says Lidén.

Another area that appears to be growing in popularity is managers launching new funds to target different market sectors and deal types, which seems less radical than the distinction between a debt fund and an equity fund. Erstwhile buyout house Inflexion Private Equity recently held the first and final close of its new £400m Partnership Capital I fund, which takes minority stakes in UK mid-market companies.

Speaking to unquote" about the new fund at the start of October, Inflexion managing partner Simon Turner commented that US funds have begun to combine buyout and growth strategies and that he "wouldn't be surprised if we see more people doing it in Europe".

It is this exact scenario that has made some LPs wary – the combination of investment strategies within a fund or a team. "Again, as long as you've got a dedicated team to drive each separate strategy, then in theory that's fine – as long as it's clear to all investors," says Gunn. "The problem LPs tend to have is the blurring between which investment fits in which pot – where is the line drawn?"

Firms such as Ardian – not to mention US pioneers such as KKR and Blackstone – are testament to how private equity firms can successfully turn into quasi or full-blown asset managers. Smaller firms tempted to walk in their footsteps might want to carefully assess their existing LP base though – for some fund investors, the responsibility of allocation across the private markets is a job to be undertaken by themselves, not the GP.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• Investments
• LPs
• Branching Out
• Top story
• Ardian (formerly Axa PE)
• Aberdeen Standard Investments
• Adveq
• 3i