| Lionel Erdely, Investcorp |
Barry Rosenstein of Jana Partners, William Ackman of Pershing Square Capital Management, Nelson Peltz of Trian Partners and Jeffrey Smith of Starboard Value have a fairly easy way to gather ownership stakes outside their main portfolios when they think a company needs an overhaul. These activist fund managers have all set up co-investment vehicles in partnership with funds of funds, pension funds or other investors over the past couple of years, according to people familiar with the firms’ activities. Jana, for example, has a co-investment vehicle with a three-year lockup period that is aimed strictly at activist strategies. Co-investment vehicles, in which a hedge fund manager pools resources with one or more select investors for a specific investment outside the fund manager’s regular portfolio positions, have helped make it possible for hedge fund managers to put more of their money into positions where they have a strong conviction. It’s a popular device among activist managers because it allows them to build positions in a company above portfolio concentration limits that they’ve spelled out in their rules or imposed on themselves in order to limit their risk. But credit and special situations managers are starting to use co-investment vehicles too, especially for illiquid positions such as reorganizations, trade claims and capital structure arbitrage. Other firms that have set up co-investments, according to industry sources, include Pine River Capital Management, Solus Alternative Asset Management and Taconic Capital Advisors.
In the past few years, these co-investment vehicles have begun to catch on among hedge fund firms, which are starting up new ones in the months ahead. These vehicles have long been a standard practice in private equity, but for various reasons hedge funds had been late adopters or used them only sporadically until the past couple of years. That is in large part due to the anti-illiquidity malaise that has hung over hedge funds since the financial crisis and is just beginning to abate, according to a study released by JP Morgan earlier this year. Hedge fund managers are starting to find that co-investment vehicles are a big improvement over the old side-pocket funds that many started during the height of the financial crisis as a way to hive off highly illiquid investments from their main portfolios and not be forced to sell those assets into a falling market at fire-sale prices. Investors, burned by the experience of suddenly finding out just how much their managers had plunked into illiquid assets, subsequently paid strict attention to their portfolios to make sure their hedge funds’ liquidity terms matched their underlying investments.
Managers are finding that co-investment vehicles are a way to get back into illiquid assets while giving investors a much better handle on what’s liquid and what isn’t. This time, investors know just how long their capital will be locked up. Also, co-investment vehicles offer discounts over the 2 and 20 fee structure — in some cases waiving management fees entirely — and they’re presented as a chance for the investor to share the rewards of a very high-conviction investment. Of course, the investor shares the risks as well, and the discount is compensation for a lockup period of one to five years, although some large investors report that they have been able to negotiate agreements that let them liquidate early if they choose to.
With the lockup period, it is too early to gauge how well most of these vehicles have performed, but expectations are high. Aurora Investment Management in Chicago, a fund of funds with about $9.2 billion in assets, has an energy-related co-investment with Keith Meister’s Corvex Management that rose more than 30 percent in its first year. Investors generally hope for earnings somewhere in the double-digit neighborhood, though often the returns come only at the end of the lockup period, similar to the way that private equity fund managers expect to reap their profits after several years.
With managers who set up co-investment deals with their largest activist positions, the stock can wither or ride a roller coaster until the manager completes a turnaround plan. Jana’s co-investments are generally in their top positions; a co-investment in the Walgreen Co., Apache Corp.and PetSmart would as of today be up less than 1 percent year to date, but with very high expectations of future performance.
Investors don’t go into these vehicles unless the hedge fund manager himself is so excited that his enthusiasm becomes infectious, so from the investor perspective, it’s a way to assure a strong alignment of interests.
“We want it to be something our managers are pounding the table about,” says Justin Sheperd, chief investment officer at Aurora.
Aurora is in eight co-investment deals, three of which were finalized in the past month. At least three of the eight deals are in partnership with event-driven hedge funds, according to an investor report obtained by Alpha. The investor report doesn’t name names but says one such vehicle is set up to benefit from the trend of increasing bank consolidation, while another is in a company that owns a chain of casual dining restaurants.
Lionel Erdely, head and chief investment officer of hedge funds at Investcorp in New York, hasn’t been waiting for the hedge fund managers to come up with those big infectious ideas. The managers at Investcorp have generated their own plans for the four co-investment vehicles they’ve set up since 2011. Investcorp’s first co-investment vehicle was in a corporate restructuring, and the firm brought in three hedge fund managers as partners. Two of the other co-investments are in commercial mortgage-backed securities, while the fourth is in regional U.S. banks. Erdely is currently considering a fifth that would capitalize on the deleveraging of European banks.
Investcorp, which manages $11.4 billion in total assets and $5 billion in hedge funds, has the advantage of a large internal balance sheet that Erdely can use to get a co-investment vehicle off the ground and then keep bringing in investors. He sees these deals as a way to add value to a fund of funds at a time when many funds of funds are struggling to redefine what they can do for investors.
Another way that hedge funds are using co-investments is far removed from activist campaigns or illiquid credit positions. David Saunders, CEO of the Franklin Templeton-owned fund-of-funds firm K2 Advisors in Stamford, Connecticut, which manages $10 billion, is looking at co-investments as a way to get into niche investments, generally with a three- to five-year time frame.
“In the area of intellectual property rights, co-investment opportunities can cover a wide range of areas including investments in movie rights, music rights, drug royalties or even book rights,” says Saunders. “Typically, the appeal of these types of investment options is the appealing streams of income some of these investments can throw off.” He has also looked at opportunities in water rights. And, says Saunders, the loans that came out of the formation of the Troubled Asset Relief Program during the financial crisis could have gone into a co-investment vehicle. Hopefully, that opportunity won’t arise again anytime soon.
