Placement agents catalyse European institutional i
With the number of placement agents on the increase David Johnson of Deutsche Bank’s private equity team explains their role in the market place
European institutional investor interest in private equity has exploded in the past three years both in terms of numbers of investors, percentage of assets allocated to this asset class, and absolute value of commitments made. While European investors still lag their US counterparts in all three categories, the growth rate of interest is substantially higher on this continent than anywhere else in the world. Alongside, and in some cases leading, this growth has been an increase in the number of introducing intermediaries, or placement agents offering private equity funds to European pension funds, insurance companies, funds of funds, family offices and government institutions. Thus professional investors now have the opportunity to access and assess private equity fund deal flow directly through their own networks, through specialised consultants and gatekeepers, from investor relations principals of the funds themselves and through a variety of types of placement agents. These range from one-person specialists, to independent merchant banks focussed on placing private equity, to specialised departments within global investment banks dedicated to raising funds for private equity sponsor groups. It is useful to explore the role of the placement agent, particularly from the perspective of the European institutional investor.
Not long after the European institutional investor indicates any level of interest in private equity, he is likely to receive a call, and then another and another, from one of the several placement agents that tread the continent. Technically, the placing (or placement) agent acts as an agent for the issuers of privately placed securities. The issuers are usually general partners or so-called sponsors of private equity funds or limited partnerships. The placing agent is engaged by the fund sponsor to procure investors to commit directly to the offered partnership, thus the agent does not act as a principal in the transaction, as it would if it were an underwriter or an initial purchaser in a public offering of securities. Often, the placing agent is also the corporate finance adviser to the fund, and recommends appropriate structures, terms and economics to the sponsor of the fund. The agent, in collaboration with the general partner and its legal counsel, usually prepares the private placement memorandum, and the marketing and presentation materials as well.
The placing agent is compensated in almost all cases on a success fee basis by the issuer, who may come to market with a new fund every two or three years. But the agent’s more permanent relationship is with investor clients. Their satisfaction with the consistency and quality of the offerings, service leading to and following the closing, and overall satisfaction with the agent’s understanding of his appetite, allocation and process of selecting private equity funds all factor into the agent’s overall success in a competitive marketplace. As intermediator, the placing agent’s imperative is not just to introduce, but to create satisfaction on both the issuing and investing sides of a long term relationship.
While each agent, through his introductions, has the same objective of facilitating wealth creation for both issuer and investor, there is a range of specialties, core competencies and service levels for European investors to choose from among the various agents. The business of placing private equity is surprisingly concentrated, with relatively few players. In Europe, they are organised as follows:
One-man show: There are several individuals who have developed a specialty of placing private equity funds with European investors. With limited capacity, but unlimited dedication to a relatively small number of issuer and investing clients, these agents can usually devote a significant amount of time to any given transaction and to fielding investors’ inquiries. They tend to work on smaller ($100m–200m) funds, which they source through their own network. The due diligence process is often partially outsourced. Investor loyalty can be very high, thus these agents have a relatively small, but active, investor base.
Independent merchant banks: European investors benefit by the recent creation in London and on the continent of several small merchant banking partnerships specialised in the sourcing, structuring and placement of private equity funds. Following a very successful formula initiated in the US, these agents – often alumni of larger investment banks – work on US brand-name funds migrating their fund raising to Europe, as well as on smaller niche strategies of indigenous European funds. Some such merchant banks have a corporate finance capability and perform their own due diligence on their client’s funds, while others subcontract that work. The independents tend to work on four or five funds a year, each in the $100m–300m range, and have the capability of placing larger funds as well.
Captive placing agents within investment banks: A handful of US and European investment banks have fully dedicated private equity placement teams servicing the European institutional investor community. The captive placement business is surprisingly concentrated, probably due to the long ramp-up periods and consequent costs associated with finding and developing transactional relationships within Europe’s evolving but somewhat opaque institutional investor market. The investment banks – usually working on a global fundraising mandate – tend towards agenting larger private equity funds, and more of them. Given the extensive capital that the global investment banks commit to private equity funds themselves (Deutsche Bank, for example, has approximately $3bn committed off its balance sheet as a limited partner in private equity funds), as well as leveraged finance, M&A, and IPO relationships some of these banks have with buy-out and venture capital funds, it is no surprise that if the banks can demonstrate an efficient distribution capability they have access to a very broad selection of private equity fund strategies. The larger captive placing agents are thus able to offer European institutions 10–15 agented private equity funds annually, diversified by geographical and sectoral focus and strategy. In addition, the larger banks often invite third party investors into to their own merchant banking funds to invest alongside the banks’ venture, expansion capital or buy-out platforms.
Drowning in paper
The trickle of US and European private equity partnerships that, only a few short years ago, made its way to the desks of European investors has surged to a tidal wave of investment product. According to Private Equity Analyst (January 2000), last year alone 361 US-based private equity funds raised money, and a healthy percentage of these offerings – whether agented or not – landed on European investors’ desks. Add in European, Asian, Latin American and emerging market offerings, and the total probably exceeds five hundred separate and distinct private equity funds in the market at the same time.
According to EVCA, new commitments to European funds grew from less than u8bn in 1996 to more than u20bn in 1998. So, both the supply and demand are ramping up nicely, but the market remains inefficient. Many European investors are swamped in paper. Largely lacking the fully staffed internal buy side analytical teams or external gatekeepers or consultants that screen, evaluate and select funds for institutional investors in the US, European institutions starting their private equity programs often complain about being ‘overwhelmed with opportunity’. In private equity this is not necessarily a good thing. Bearing in mind that,over the long term, the spread between upper and lower quartile returns in private equity is on the order of 15–20% per annum, it is imperative for investors to build their fund portfolio around strategies that are most likely to maintain their upper quartile position or, with newer strategies, earn their way in. Another way of looking at it is if these historical paradigms hold up in the future, three out of four funds being raised now are likely to register performance that is average at best, disappointing at worst. So the volume of opportunity as reflected in the preponderance of funds being marketed in Europe doesn’t necessarily make the investor’s life easier.
Why is there so much new interest in raising private equity commitments from European investors? US sponsor groups or general partners (GPs) cite several reasons:
Diversification of funding sources: Public equity market corrections, change of policy, change of personnel and many other factors may impact the allocations of traditional sources of equity in the US
Raising capital in Europe creates ancillary opportunity: Fundraising and the creation of multiple new strategic investor relationships often leads to value creation opportunities for portfolio companies through expansion into Europe and in some cases evolves to a principal investing in Europe.
Accelerated fund raising cycle: European investors are seen often to be more rapid and efficient in their decision making process, they get to ‘yes’ or ‘no’ with fewer meetings and fewer layers of review. The perception is that they may be more relationship-driven than process oriented. All said, most general partners would rather be investing money than raising it. If offering the fund in Europe creates a more efficient overall fund raise, few US issuers would argue. Many of them, too, would rather spend a night in Paris, London or Munich than Madison, Tallahassee or Sacramento!
Now that the European institutional investor community is taking a more professional approach to private equity investing, UK and continental European sponsor groups who used to raise most of their capital in the US are seeking European investors for many of the same reasons, ie diversification of funding and efficiency and acceleration of the fund raising process. Additionally, European GPs often seek:
Validation of strategy: Cornerstone commitments from European institutional investors are often of critical importance to, especially, newly formed European partnerships, as ‘home grown’ investors are presumed to know a great opportunity when they see it.
Strategic tie in: Many European institutional investors can and do offer strategic and tactical help with deal flow, management, value creation and exit, and are a ready and quick source of co-investment.
European institutions used to complain, rightfully, that they were not getting the first bite of the apple on US-sourced deal flow, ie they felt marginalised in not being shown the best deals and not being given enough time to properly evaluate and react to so-called ‘blowout’ funds. This has changed and continental investors are beginning to recognise that highest quality private equity funds can now be offered to them in parallel or even ahead of the US placement of the same fund. This is particularly important for those investors who wish to participate in terms negotiation on early versions of the partnership’s legal documents, and for all investors who hope to obtain a full allocation in early rounds. A close working relationship with the placing agent helps the European investor see all the agents’ deals, to see them early enough in the process to subject them to a normal period of evaluation, and commitment.
Good placing agents can help bring a certain degree of efficiency, rationality and transparency to a process that can be very inefficient, random and opaque. The agents, who most often have a solid corporate finance background, are best able to provide a value added service to institutional investors if – as the relationship evolves – they develop an understanding of the institution’s overall allocation for private equity and how that is broken down by geography, sector and type of strategy (ie venture capital vs expansion capital vs leveraged buy-out vs mezzanine). The agent would normally know the investor’s processes, its key people, and have a general understanding of their normal bite size and the length of time required to come to a decision. They would understand whether the investor is return-driven only, or evaluates opportunities in a risk adjusted return framework, as well as whether the investor is interested in co-investment or – especially with insurance companies – mezzanine financing opportunities.
If this all sounds like a lot of work, it is! Given that the European institutional interest in the asset class seems to have outpaced the development of buy side experience, the placing agent – as a ‘missionary marketer’ of sorts – can be in a position to transfer relevant knowledge and information to his newer investor clients and help accelerate their learning process. With more experienced investors, the agent effectively is an extra set of eyes and ears, and a conduit into the deal flow of his or her organisation. In either case, the agent is called on by both the issuer and investor to engineer efficiency in matching a particular private equity investment team and strategy with a known potential interest in such a fund.
Sourcing deal flow
Placement agents captive to global investment banks see several hundred partnership offerings a year, and work only a fraction of those on their fund raising. While some agents specialise in distributing so-called ‘brand name’ rollover funds that are allocating most of the new fund to existing investors and asking the agent to introduce a handful of new investors, others specialise in raising capital for spin off funds, new-to-the-market strategies, emerging market funds and smaller, very high IRR potential venture capital funds. Many fund raising engagements are sourced through referral from both sponsor or investor clients. Captive investment bank agents are introduced to top LBO and venture funds by financial sponsor group relationship managers and M&A advisers within their bank. GPs looking for an agent often organise a so-called ‘bake off’ or ‘beauty contest’, and invite three or four agents to pitch for the business. Last but certainly not least, the placement agent researches investment performance and fund raising cycles and, based on expressed demand from bellwether investors, pro-actively seeks the fundraising engagement long before the fund is ready to take in new investors.
The screening criteria that the placing agent uses to narrow its selection of GP clients is similar to that which a potential investor employs, particularly related to the quality of the partnership and the soundness of investment strategy. The agent is compensated by the GP on a success-only basis, but is aligning its interests with the investors by deploying corporate finance and marketing capacity on the supposition that potential investors will agree with the attractiveness of the offer.
Not many private equity fund managers approach a potential investor saying, ‘our team hasn’t worked together before but we are hopeful we can sort out a few differences on how we share the partnership’s carry, assuming we beat a hurdle rate and can at least give you back your capital after 10 years’. In fact, pretty much everyone coming to market describes themselves as an experienced team, with exclusive deal flow, upper quartile returns, a unique investment strategy, and LP-friendly terms. The reality of most funds is certainly not as bleak as the former representation and not as rosy as the latter.
Given the paucity of publicly available information on private equity sponsor groups, the ever changing dynamic of the market place, and structural constraints following the investment decision (investors leave a lot of money on the table if they liquidate partnership holdings before they mature), due diligence on the partnership, its people, its portfolio and representations it is making are critically important for potential investors. But it is difficult for many understaffed European investors to do proper due diligence, particularly in the short period of time many attractive fund offerings are in the market.
Many placement agents do extensive due diligence with their own corporate finance specialists prior to agreeing to agent a fund. A team of four (usually a Managing Director, VP, Associate and Analyst) work their way through a detailed checklist over a four to six week period. The process should be as rigorous or more so than that of its most experienced institutional investor or its advisor. Good due diligence involves not only multiple, iterative meetings with the GP, but extensive reference calls to previous LPs, bankers, lawyers, accountants, former employees and associates, portfolio company executives, prior co-investors and other professionals who have done work with the GP. The reference checking is done not only to help validate the GP’s investment story and confirm factual points of attribution (it is important to be able to understand responsibility and cause for both successful and unsuccessful investments) but to try to assess the GP’s character, ethics and integrity. Agents document and are often in a position to share the essence of their reference checks with interested investors. The business of buy-outs is sometimes not so clean cut, and reference calls sometimes turn up grey areas which are important for the GP to be encouraged to address from the outset and for a potential LP to evaluate along with more straightforward detail.
The placing agent’s due diligence also assesses real and potential conflicts of interest in the GP, and the uniqueness and sustainability of deal flow. The agent tries to develop a precise understanding of both the financial structure and accounts of each portfolio company as well as the strategies employed to create value in these investments. The depth of the management team and degree to which incentive compensation is shared are also important considerations in the due diligence process. And, of course, the fund’s positioning in its peer group and its realised and unrealised investment performance, measured both by internal rates of return and multiples of equity returned, are critical issues for the agent to assess. There are several ways of calculating IRRs and it is incumbent on the placing agent to use in all analyses a method that more accurately and conservatively reflects a fund’s performance. Interested potential investors should be able to access through the placing agent not only the spread sheet analyses on which the returns have been modeled, but also the underlying cash flows and income statements of the fund’s portfolio investments, and, importantly, the analysis the agent used in valuing unrealised investments. Investors are encouraged, of course, to run their own analysis off the same numbers and the placing agent’s corporate finance team are in a position to provide assistance as necessary. This is particularly true in Europe, where fewer institutional investors have gatekeepers or advisers to perform this function and who are often understaffed with experienced private equity fund analysts. Yet, according to the newly released annual Report on Alternative Investing by Tax-Exempt Organisations, 1999 (jointly produced by Goldman Sachs Company and Frank Russell Company) virtually all of the main fund selection criteria cited by European institutional investors are subjectively determined eg ‘Quality of internal organisation’, ‘GP reputation’, ‘frequency and quality of communication’, ‘sticks to proven strategy’, and so on. Fund selection is a humbling process. Experienced investors seek all the help they can get!
The placement agent generally shares its due diligence information with potential investors in the form of an information package with a standardised format, including quantitative information in disc form and a completed due diligence questionnaire. Anticipating most investor questions and organising responses into a user friendly format helps all parties to the potential transaction – the GP, the LP and the agent as intermediator – work their way through this process efficiently. To the extent that tailor-made questionnaires need be completed, or specific responses to questions that have not been addressed in the due diligence package are required, the placing agent stands ready to help the LP with those. Often, the potential investor will ask for access to a data room during on- site visits to the GP’s office and the placing agent assists in this process, which usually focuses on reviewing actual deal logs and internal investment proposal memos and other documents that may not have made their way into the due diligence package. The placing agent might also be called upon at this stage to provide information on sensitive issues such as the split of carried interest among members of the GP.
The placement agent’s role in the due diligence process is thus critical, both in terms of generating the original analysis and in working with the potential investors to get them comfortable with the analysis. Over time, the institutional investor, working through the sales coverage or relationship manager of the agent, often views the corporate finance unit of the agent as an extension of his analytical capabilities, particularly for private equity funds that are outside his geographical region or in a sector in which he has less experience.
Getting to the close
Access to top performing private equity funds is increasingly difficult. Particularly for European investors who are not ‘grandfathered’ into top partnerships through commitments made a decade or so ago, accessing a reasonable stake in promising funds is sometimes made easier working through agents. Once the European investor has made his ‘hard circled’ commitment (he has named a certain figure and is committing to investing at that level, subject to legal review of documents and further due diligence) many investors continue to look to the placing agent for help in getting to a clean close, particularly on questions of the legal documentation, timing and allocations.
Legal documentation: The standard legal package for subscribing to a private equity fund includes the actual partnership agreement, subscription forms, and addenda. While the placing agent is not the legal adviser either to the fund or the investor, it can often facilitate the communication process between the investor and the lawyers advising the fund. Private equity lawyers are often in their best element talking to other private equity lawyers in the same language and in the same time zone. The agent is often well positioned to translate the real wishes of the investor to the fund’s lawyers, and vice versa.
The placing agent would also know which of his European clients are interested in participating in the negotiation of terms that characterises many partners who participate in the first closing.
Timing: Best laid plans aside, most private equity funds do not close on their original schedule. Accelerated closings occur when relatively small and capped funds find a resonance in the market and the partners decide to close out the fund quickly rather than reach out to additional possible investors. Occasionally, committed investors cannot react in time to the new, accelerated closing schedule and they fall away. Or, more commonly, the final closing of a fund is delayed to accommodate a particular investor. In either case, the placing agent should be in a position to advise the potential investor on the most likely timing scenarios it will face and to try to facilitate the process on both sides, an exercise akin to herding cats!
Allocation: The placement agent plays an important role in guiding the GP’s thinking on what the final composition and allocations in the partnership will be, but the decision ultimately rests with the GP. The debating of the allocation between the agent and the GP is sometimes not without friction. The LP’s and the agent’s interests are certainly aligned and the agent will do his best to obtain a full or reasonably full allocation. But given the tendency of GPs to cap funds, particularly smaller ones, and the tendency of LPs to overcommit to private equity funds (if an investor wanted, for example, an average $5m actually invested annually, he may commit $35m, knowing that he may be scaled back to $25m and on average $5m will actually be invested) the math sometimes doesn’t work out. Helping the GP match supply and demand in shaping the partnership, and shepherding it to a clean close are the final roles played by the agent in any particular fundraise engagement.
Private placement of private equity securities has traditionally been less efficient than the distribution of other securities in Europe. With a proliferation of funds, of placing agents and of institutional investors in this asset class, it is likely that the current trend towards distribution efficiencies will continue, up to a point. It is also likely that technologies, particularly the use of the web to distribute due diligence information right down to the portfolio company level and other partnership documentation, as well as increased use of conference calls and video conferencing will replace some types of face to face meetings. One can also expect a fragmentation of strategies, particularly of European country specific strategies with a sectoral focus, and venture capital strategies. Further, European private and investment banks have been on the front end of innovation with respect to special purpose investment vehicles that provide easier access to private equity investment strategies. These include listed and liquid funds of funds, convertible notes whose underlying investments are in private equity funds, and retail oriented feeder vehicles.
Alongside such technological and product structural changes, the placing agent’s role will continue to evolve along higher value added models. The agent’s judgement in screening and selecting private equity investment opportunities and matching them to the European investor’s appetite will be augmented, not replaced, by technologies. Both sponsors of and investors in top performing private equity funds will continue to seek to find and do business with each other in the most efficient manner possible, which will often be through the placing agent.
David Johnson is a managing director at Deutsche Bank and is the head of the investment bank’s Private Equity Finance Group for Europe and the Middle East. He can be reached at firstname.lastname@example.org