The Rise and Rise of Direct Investment
The boom in private equity has historically been driven by traditional “blind pool” private equity funds. This remains very popular and is a well-trodden path with demonstrable success. However, in recent years, across the international investment landscape we have seen a huge increase in the number of “deal-by-deal” PE managers providing access to direct investments in target companies to their investors.
Some deal-by-deal operators have emerged out of necessity, where they have been unable to raise a traditional blind pool fund. However, others entered the fray to either serve an investor base with an appetite for greater control over their investment decision making (and risk), or indeed to address deals, and/or deal structures, that traditional PE funds cannot fulfil, or deliver on.
Investors are allocating an increasing portion of their private equity commitments to direct investing, backing what, in the US, is referred to as a “fundless sponsor”. Here in the UK, we have seen a number of market entrants successfully provide investors with access to lower-mid-market and mid-market deals on a deal-by-deal basis over the last decade.
Years ago, we identified that certain investors, particularly the more private investors such as family offices, and Ultra-High/High Net Worths, have fluctuating liquidity (which is a factor), and also wanted to have greater control over the investments they choose to get involved in. Deal-by-deal sought to address this, allowing them to pick and choose when to participate to suit their own cashflows and their investment appetite at the time.
However, over the years, what also became clear was that having total flexibility, unencumbered by the traditional PE fund “rules” (set out in the fund investment agreement with LPs) meant being able to be more creative about deals. Its less a case of having to force our square peg into someone else’s round hole – need high yield debt or fixed return preferred equity?… no problem, need minority investment for an eight-year hold period?… no problem – the fact is the investors themselves get to decide what works for them in a given scenario, which makes the deal-by-deal operator more flexible.
This works the same way with sector limitations too. We recently had a business on our desk involved in defence (a sector which for obvious reasons is in a current period of strong growth) – which the PE funds had universally declined based on ESG concerns, and in most cases forbidden by the “rules” of the Fund. Not bound by these same limitations, a deal-by-deal operator can consider a deal like this and leave it to investors to determine whether they wish to participate in it. The end investor can take their own view on the ESG matter, rather than having a blanket approach. This could be the same in a plastics business, a sex toy business, or a CBD products business, all of which have crossed our desk with the same problem for blind pool PE funds.
And certainly, the rise of the direct investment class has brought a whole new generation of investors into the asset class. Where private equity would historically have been the domain of institutions and the super wealthy, some managers have made it possible for investors to participate in deals for a few thousand pounds. This provides access to a whole new cohort of investors, which some would argue is increasingly democratising the asset class. Some deal-by-deal operators have investor databases which run into thousands of names.
Investors have also told us that they like that, as a deal-by-deal manager, we are more aligned with their interests because our economics come from co-investment in sweet equity – we sit in the same instruments as our investors. We don’t need to “trigger carry” in a fund or sell businesses at a sub-optimum moment to provide the exit credentials needed during the fundraise for the next fund. We sit alongside our investors maximising returns for them on a specific asset – and investors seem to like that. Added to which, deal fees are also deal-specific – investors tell us this is preferred rather than the AUM fees of a traditional fund. That said, we do see some deal-by-deal operators charging comparatively high deal fees, but like all things this will have a way of finding its market norm (much like it has for traditional funds).
There are undoubtedly pros and cons for both the model of a traditional fund and the deal-by-deal model, but both are here to stay and the continued growth of the latter may provide new tools and opportunities for vendors, shareholders, management teams and intermediaries on deals, and with that, greater opportunity for a wider and deeper pool of investors. Interesting times indeed!
Further Information
Del Huse is Founder and CEO of deal-by-deal investor Roycian Ltd. www.roycian.com
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