Buying In: SWFs Partner with Private Equity Firms

May 13, 2013 by Simon Meads

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WHEN LONDON-based private equity house CVC Capital Partners sold a 10 percent stake in its business to a group of international sovereign wealth funds last summer, hardly anyone knew it. The firm’s limited partners only found out at CVC’s annual meeting in September, after the deal had been finalized. Even then CVC did not reveal the names of the buyers or the price. Bound by confidentiality constraints, the firm’s general partners kept quiet. Only recently, in private meetings, have they hinted at their investors’ identities.

The sale of the 10 percent stake to — according to industry sources — Government of Singapore Investment Corp. (GIC), the Hong Kong Monetary Authority (HKMA) and the Kuwait Investment Authority (KIA), was just the latest in a string of unusual deals struck between private equity firms and their sovereign wealth and pension fund clients. Starting in 2000, when Carlyle Group sold a 5.5 percent stake for $175 million to the California Public Employees’ Retirement System (CalPERS), a giant, $255 billion state-run pension fund, a handful of the biggest private equity firms have cozied up to their largest clients by selling them small minority stakes in their management companies.

Such deals have allowed private equity executives to cash in on their equity stakes or expedite the valuation of a firm’s management company in anticipation of an IPO, but they have also raised questions among the firms’ limited partners. No one wants to think that another investor might interfere in a firm’s decision to deploy capital. Some limited partners also worry that their private equity managers could lose their competitive edge once they sell stakes in their businesses. But for most investors the phenomenon is just another reminder of the power that sovereign wealth funds (and even some pension funds) wield when it comes to securing a better deal, whether they’re seeking to lower their fee loads, gain more access to prized co-investments or take a cut of the management company’s profits.

For sovereign wealth funds the attractions are obvious. In the aftermath of the global financial crisis, sovereign investors have been working harder than ever to deploy capital in profitable, risk-adjusted ways. Direct investments are on the rise, but deal sourcing is still a challenge. The largest sovereign wealth funds, which manage vast amounts of capital, are keen to learn from best-in-class private equity firms. The benefits are not lost on the private equity groups, which have been able to lock in some of their wealthiest limited partners to provide them with a supply of capital for years to come.

"Sovereign wealth funds are looking to deploy money in attractive investments with private equity firms that they perceive to be great investors," says Alexander De Mol, a London-based partner at global management consulting firm Bain & Co. who advises both private equity firms and sovereign wealth funds. "There is also a strategic rationale. They get to understand how private equity generates alpha and gain more exposure to the entire alternative asset space. But when we see sovereign wealth funds doing this, there is always a financial element too."

Given the secretive nature of the institutions involved, only a few such deals have ever been made public, but they are clearly happening with greater frequency. In 2007, for example, Carlyle sold an additional 7.5 percent to Abu Dhabi’s sovereign development fund, Mubadala Development Co., for $1.35 billion. That same year China Investment Corp. (CIC) took a 9.4 percent stake worth $3 billion in Blackstone Group at the New York–based firm’s initial public offering (a stake raised to 12.5 percent in 2010). New York–based private equity firm Apollo Global Management sold an 18 percent stake to CalPERS and the Abu Dhabi Investment Authority (ADIA) in 2007, and in 2009, Fort Worth, Texas–based buyout powerhouse TPG Capital sold a 5 percent stake to KIA and GIC for $500 million. Meanwhile, in Europe, London-based private equity firm Apax Partners sold a total of 10 percent to Australia’s Future Fund, CIC and GIC in 2009. (All of the private equity firms and sovereign wealth funds declined to comment or did not respond to requests to comment for this story.)

The number of such deals may always be constrained by managers’ desire to retain their independence, but sovereign funds are fast becoming a major market force given the size of their assets under management. According to Institutional Investor’s Sovereign Wealth Center, sovereign wealth funds currently manage more than $3.4 trillion — and that total continues to rise. Sovereign wealth funds are now managing more money globally than the private equity industry, which oversees $3 trillion in assets, according to market research firm Preqin, although the proportion of sovereign funds’ assets invested in private equity is quite low at an estimated $131.3 billion. Bain forecasts that an additional $30 billion to $60 billion could flow into the private equity industry from sovereign wealth funds in the next couple of years.

If those allocations materialize, sovereign wealth funds could overtake foundations and endowments to become the third-largest investor group putting money into private equity, behind public pension plans, which currently account for 29 percent of invested capital, and private pension plans, which invest 14 percent, according to Preqin’s data. But these days sovereign wealth funds are less inclined to invest in passive, pooled investment funds. They’re pushing to conduct more deals themselves, either alongside private equity firms as strategic co-investors or on their own.

"Across the board, sovereign wealth funds have been increasingly investing directly. They are actively buying direct stakes in companies on their own or as part of a consortium," says Richard Good, a partner at law firm Linklaters, which advises sovereign wealth funds seeking to invest in private equity firms’ management companies or make co-investments.

Taking stakes in leading buyout houses is one way for sovereign wealth funds to learn the ropes from leading deal makers before putting those lessons into practice. The funds’ executives can sit on the board of a private equity firm’s management company, deploy staff to work on the firm’s team or get the private equity house to send its professionals back to the sovereign fund’s home office, says Jonathan de Lance-Holmes, head of Linklaters’ investment management group in London. He sees parallels with real estate investing, in which some of the largest sovereign funds, such as ADIA, have cut out the investment middlemen and now buy large property assets directly. De Lance-Holmes believes that ADIA, among others, could do the same in private equity within the decade.

Some sovereign wealth funds have already begun striking their own high-profile, multi-billion-dollar private deals. In 2009, Qatar Holding, a subsidiary of the Qatar Investment Authority, bought the Chancery Building in London’s Grosvenor Square, a former U.S. embassy, for £300 million ($490 million). A year later Qatar, which has a penchant for picking up trophy assets in the U.K. and Europe, acquired British department store Harrods for £1.5 billion; in 2012 it took a 20 percent stake in London’s Heathrow Airport Holdings for £900 million. But lower-profile deals, such as GIC’s acquisition of an 18 percent stake in German media group Springer Science+Business Media Deutschland in 2009 alongside Swedish private equity firm EQT, for which they paid €2.3 billion ($3.4 billion), may provide a clearer indication that sovereign funds are increasingly powerful and proactive investors alongside their private equity colleagues.

Not all sovereign wealth funds want to strike deals on their own, however. Some are more intent on learning negotiation tactics, polishing their due-diligence skills and planning exit routes — all of which may help them assess potential co-investments more effectively, says Linklaters’ de Lance-Holmes. Gaining that understanding can help sovereign investors make better returns from their money with fewer risks, because co-investments are not subject to management fees. Although taking a stake in a private equity firm’s management company is not a prerequisite for gaining access to those deals, it surely helps.

Private equity firms can be attractive investments in their own right because they pay out dividends from their hefty management fees. If CVC succeeds in raising its target of €9 billion for its sixth European buyout fund, it could generate €135 million a year in management fees (assuming a market standard rate of 1.5 percent) before investment profits, or carried interest, as it’s known in the private equity trade, start to roll in.

"There are very few businesses where you can ink in your top line with precision for the next five years, but private equity, with its fees on committed capital, is one such business," says William Gilmore, a private equity investment director at Lloyds Banking Group’s Edinburgh-based asset management business, Scottish Widows Investment Partnership. "For any incoming investor that long-term dividend play can be quite attractive."

Sovereign funds have to be wary of the firms they invest in, however, because not all of these deals have delivered. Carlyle’s 2011 IPO, which saw the firm’s stock list at $22, valued the group at well below half the price Mubadala had paid for its stake; Carlyle’s subsequent price rise to $32 per share has helped Mubadala recoup some, but not all, of the lost value of its investment. CalPERS’s relationship with Apollo made headlines for other reasons: The U.S. Securities and Exchange Commission alleged that former CalPERS chief executive Federico Buenrostro and onetime board member and fundraising middleman Alfred Villalobos had faked documents that allowed Villalobos to claim millions of dollars in fees from the private equity firm. Both Buenrostro and Villalobos have denied any wrongdoing, but they were indicted on fraud charges in March. Meanwhile, both CalPERS and ADIA are taking advantage of an end to the lockup periods on their Apollo stakes to sell about one quarter of their shares, worth about $140 million each.

For private equity general partners, the decision to sell a stake in the management company is all about the money. Realizing a firm’s value, even in part, can mean generating sufficient cash to buy out its founders at retirement; increase its operating capital to expand the business internationally and set up new divisions; or guarantee a cornerstone investment for its latest fundraising round. The investment in CVC by the trio of sovereign wealth funds, GIC, HKMA and KIA, is helping the firm expand its burgeoning debt management business, CVC Credit Partners, its infrastructure business and its core private equity arm.

Far from putting off other investors, sovereign funds’ investments in general partnerships can help private equity firms burnish their brands, says Antoine Dréan, chairman of Paris-based Triago, a placement agent that helps private equity houses raise capital. "They serve as an important stamp of approval with LPs [limited partners] when fundraising, even if it is evidence of the relatively greater clout that large investors wield," Dréan says. Such deals can also ease the firms’ access to new deals in places like China and Southeast Asia, providing important validation for target companies and politicians alike. In the three years since Apax sold a stake to CIC in 2009, for example, the firm has sealed two deals in China, investing in online property platform SouFun Holdings (alongside General Atlantic) and buying restaurant chain Golden Jaguar.

"Only an alarmist would have a particular concern about a sovereign investing in a GP [general partner]," says Alan MacKay, chief executive of London-based independent private markets specialist Hermes GPE. He notes that most of the deals struck are for stakes of only 10, 20 or at most 25 percent. "If the majority of the ownership of the management company were not owned by the partners, that would be an issue," he adds. "But I have never heard of a situation that comes anywhere near that."

Other private equity professionals are equally placid about the phenomenon.

"I find it hard to get too worked up when a small stake is sold," says Francesco di Valmarana, a partner at London-based private equity fund-of-funds group Pantheon Ventures. "Most of the time, it’s cementing a relationship and providing some liquidity at management company level, and it might just be recognizing what is de facto a close strategic relationship anyway."

No one in the industry expects these deals, which are selective and scarce, to become an industrywide trend. Many of the largest private equity groups have already sold stakes privately or listed on major stock exchanges. Others have no desire to expand and want to stay focused on their core investing process — or keep all the fees and profits for themselves. "We’ll never do it because we don’t see the benefit," says a managing partner at a large European buyout firm. Another senior executive, at a U.S. private equity firm, is of a similar view. "Most GPs don’t like it because they are giving up carry," he says.

Even fiercely held opinions can change when times are tough, however, and large sovereign wealth funds offer the glittering promise of hundreds of millions of dollars in capital. No one can doubt that they are the richest tickets in town — or that they’re using their sheer size to get better deals than other limited partners. Galling as that may be to some investors, the sovereign funds may actually complement their private equity partners’ deal making by coming in alongside them on select co-investments. Sovereign funds are intent on learning how to squeeze every last cent of profit from their investments, and by taking stakes in some of the best buyout houses, they’re already proving quick studies.


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