The New Rules of Co-Investing

You know, it will beat not apocalypse, no. It will get some, but it won't get them all. And we're believers that many of these groups are going to come out of this stronger, frankly. Welcome to Capitol Revolution, the podcast that brings you to the table for the conversations you won't hear anywhere else in the alternative capital market. Adam Spence is a partner, head of co-investments, and head of the New York office for Partners Capital. He gets on the firm's private equity in real estate and private credit asset class investment committees. Adam spent 13 years at American Capital as a direct investor in private equity and private credit. Earlier in his career, he was a real estate direct investor and an M&A investment banker. Immediately prior to joining Partners Capital in 2018, Adam served in a New York State Governor's office and was an advisor to foundations and the TPG Growth and Rise funds. Founded in 2001, Partners Capital is a global investment office with over $75 billion in assets under management. The firm partners with the Distinguished Endowment and Foundations, senior investment professionals, and prominent families across the globe to construct customized investment portfolios for its clients across all major asset classes. Thank you for joining us today. We're going to go ahead and jump into some questions, but can you give us a brief overview of Partners Capital's co-investment program, how large is it, how long has it been running, and what role does it play within the broader strategy of Partners Capital? Sure. Our first co-investment, and I'm going to focus today on private equity co-investments because that's the largest part of our co-invest program, although we do have a program really started about 17-18 years ago when we did our first co-investment deals with managers with whom we had a fund commitment. Those deals at that time I describe often as a bit of a past-the-hat situation. They were not out of a fund. They were with managers we knew very well. Generally fairly small ticket sizes. There was high conviction in both the manager and the deal. I came here in 2018 as part of a, I would describe as an in earnest launch of a larger private equity co-invest program. At that time we raised our first dedicated discretionary co-investment pooled vehicle. That was what we called the beginning of our Merlin series, Merlin 1. That was in 2019 with $150 million of committed capital. Since that time we've now raised four funds, our fourth fund Merlin 4, closed late last year at $1 billion. You talked a little bit about structure. Maybe you can give us a sense of the check size that you're looking for today and the type of deals that you're investing in. What is the range depending on the manager? Check size is something that we take a fairly broad view on. That's really a reflection of the many sources of capital we represent to invest in deals. In any given deal, we might be investing on behalf of our Merlin 4 vehicle. We might be investing funds from our Condor Fund of Funds or Private Equity Funds pooled vehicle. We might be investing from registered vehicles or other evergreen products. We might be investing for clients who come in directly into deals. All of these have different size parameters, different speed parameters in some cases. Mostly we respect to some of the direct clients coming in. We're really nimble across all of those different sources of capital. We might be doing some $5, $10, $15 million growth equity investments. We might be doing $10 to $20 million buyout co-investments in smaller deals or, frankly, even just smaller checks in larger deals. Then we are frequently and probably most frequently investing, really $75 to $85 million sort of core ticket size into private equity buyout co-investments. In those, I'd say the enterprise value of those deals is right now running at an average of about $450 million. We tend to be a large check into a relatively small deal, though we also invest sometimes in multi-billion dollar companies. It is a very open-ended mandate with respect to size. We are much more focused on what I describe as a company profile than, say, manager size, enterprise value, etc. With that, are there core sectors you're looking at currently? We're spending a lot of time like everybody probably in aerospace and defense right now. We're looking at oil-fidged services increasingly. We do quite a bit of industrials. We always have. We are wondering whether there's a bottom soon on software. We're not necessarily smart enough to call that, but we do have some view that software feels a bit oversold that there's a baby out with the bathwater situation going on and across a lot of these. Now I'd say we're in a monitoring situation on software. You're not necessarily a believer in the SaaS apocalypse. It will be not apocalypse. No, it will get some, but it won't get them all. We're believers that many of these groups are going to come out of the stronger, frankly. Do you have a target number of combests that you're looking to hit, or is it really opportunistic, and then it depends on your sizing? I'd say we're staffed to do 15 to 20 private equity combests in deals a year. It doesn't mean we have to, and there are years where we do 12 or 13, and there are years where we do more than 20. It really has to do with our staffing levels. We have about 350 plus deals coming in every year, and that's pretty consistent. It's grown a bit over time. If you think of us as sort of 325 to 375 new opportunities every year, we have a team that calls through that and prosecutes, called on average of 15. To that effect, how much lead time do you need from that first outreach or first lunch, you just put it to an actual commitment? The fastest we've ever moved from, I don't know, about a lunch, but a teaser, so to a deal preview, probably a little better than a teaser, to a commitment was eight days. I can't say we're going to do that all the time, but there was a situation where that happened, we're structured internally to deliver certain commitments as fast as we can, while still getting the right work done. Because we feel that's a huge differentiator in Coenvestland. The reality is, and we hear this all the time, and I'm sure you do, the greatest complaint we hear from sponsors is there are a lot of people who say they co-invest, but very few of them actually get it done. I think we heard that first 10 years ago, whenever it was, and said, "Let's win on that." That in itself is in some ways not that hard. It means that we have set up our team, our diligence process, our investment approval process to be, I always resist the term ad hoc because it sounds a bit loose, but I would say it is uncall. We can bring our team together at any moment, get through the materials, make a decision. We are sitting together, we are looking at deals together all day long. We really like something, we're moving on it right away because we know that raising capital is a huge burden on the sponsor, or frankly on the intermediary who's supporting them. Everybody wants to get this deal done and get back to focusing on due diligence, managing the business, and not necessarily bringing a huge number of parties through a capital raising process. On that note, do you see a larger macro trend taking effect where you're actually going to have more deal flow on the investment side? From our seat, we're seeing Blindpool Capital that is harder to raise across the board, and we think the investment market, directs market, is just going to continue to grow. Is that what you're seeing as well? Yeah, we've seen that. The way we've seen it, it's related to what you're describing, is we see more deals from more sponsors, which is to say the number of sources has increased. I would five, 10 years ago, not every manager or sponsor used co-investment, and now not every single one does, but many more do. They're using it more frequently. I think it's two things. One, they've been listening to their investors, both existing LPs and prospective LPs. Two, they realize that raising capital is hard, and it's gotten a lot harder in the last few years. One of the ways you get the attention of an LP or prospective LP is to show them a deal that you're working on. Bring them in, bring them very close. I can tell you, when we're working on a deal with a strong sponsor, we see the work they're doing. We recognize it as differentiated, as thorough, well considered, and we see their investment decision-making process much better than we can when we're evaluating. If you can move quickly and be a good partner, it could work well for both of us. You talked a little bit about the teasers that you first see in order to move. What is the ideal co-investment pitch or package of information that you receive from first clients? We really want to see. We're always going to see a teaser. One or two page teaser that tells the story, great, really important. Let's just flush out industry questions, some historic financials, who the sponsor is, where we think this is going. The next phase is that, called 40/50 page presentation. and best if that's their internal investment committee work, fine if it's a more created for external document in itself. Well, I'd say the most important thing at this stage is show us the whole story. Worts and all, as we say, right? Don't just bring us a sanitized version that's then gonna allow for surprises, three weeks, four weeks down the line when you say, oh yeah, I forgot to tell you that margins have been declining on this major customer or the concentration is actually, three customers are actually the same purchaser. The kinds of issues that we ought to know up front. And frankly, if we're working with a sponsor who is really smart and see something really interesting and a deal, we're all years as to why a risk is mitigated, as to why a challenging growth opportunity is realistic. Bring us in on that. Treat us like a partner and we'll act like one. How do you think about meetings with management? Do you actually have to have a cut deeper in order to meet with the management team or is it more focused on the sponsor themselves or is it a give and take depending on the deal? Yeah, we like to meet management, but I can tell you, we don't always have the opportunity to. So we've had to make a process decision here to say that's a nice to have, but not a must have. There are co-investors out there for whom it is a must have. We made a decision early on and it's been okay. Our results reflect the sanity of the decision, if you will, that the management meeting is something that we need at some level to be relying on our sponsor partners to really make decisions around. We are behind the sponsor we know in so much information flow. That relationship is critical. Now, our due diligence process, of course, validates what we are being told or hopes to validate, doesn't always, right, but hopes to validate or verify what the sponsor is telling us. If that sponsor is not making a good decision around management, we've got much bigger problems. We need to be figuring that kind of thing out about the quality of their work and their decision making. And then most importantly, how that sponsor manages management. One of the things we're very wise to, and we've been in this business a long time, is very frequently the management team is replaced post closing anyways. So we're not really a management first investor, because we recognize the sponsors we work with very frequently will make a decision to make a change there. You talked a bit about transparency. I mean, what are the common mistakes GPs make when they're actually bringing you a co-investment directly? It's a bit, as I mentioned earlier, it's that sense of hiding the ball, don't hide the ball. That's the number one piece of advice. Show your warts and all. 100%. And then the other one is be responsive and be transparent when we ask for data cuts of, you know, I mean, we frequently are looking for margin by customer, margin by product, gross margins usually. Show us that. Help us get under the hood. And frankly, if you haven't done that kind of work, we're going to be worried, because we view that kind of work generally as critical. We've seen channel stuffing and we've seen other tactics by sellers that some basic diligence blocking and tackling can illuminate. And sponsors who are not doing that kind of work, we probably shouldn't be doing business with. How do you think about feeing carry in these type of co-investments? And, you know, do you have an expectation depending on whether you're a primary investor or whether you are just meeting the manager for the first time? Yeah. When we're an LP and a fund and committed to that fund, we expect fee-free carry-free deals. That is built into the pricing model of a fund commitment. It's built into that relationship from day one. About 60% of the deals we've done in the last 12 months have been outside of our relationship base, which is to say with sponsors within we do not have a fund commitment. We recognize that for some of those sponsors, they need to make a living. They need to keep the lights on and they rely on some kind of income stream to do that and incentive through carry. We generally do not pay-- well, we almost never-- we have not paid management fees in a long time. We look for sponsors to draw some monitoring fee from the portfolio company. We're OK with that. We do generally look for a cap on that. We don't want that to be a source of a profit center, really, but understand that that's a way to keep the lights on. We are open to paying carry to sponsors with whom we do not have a fund relationship. The smaller they are, the more we're open to that. And you usually have a multiple of invested capital tie to that, or is it really just an IRR? No, we like to have both, because we recognize duration varies by manager. We want to see multiples over two times. We want to see IRRs over 20% target at least. And we recognize everything gets there. But those hurdles are critical. And they really are an area where, again, we're happy to pay for performance. And we paid 25% carry over higher hurdles in the past. It's not that the percentage is sharing is small, but the hurdle matters a lot. And how do you think about governance and information rights? Are you typically looking for a board observer seat, specific reporting rights? I mean, any protective provisions, as are late, due to just information? I think we have board observer seats on 8 or 10 last deals. And those are situations. Let me differentiate the two where we don't. Our very large transactions, where our $50 or $70 million is not a big number. But if we're 25% or more of a co-investment raise, we're usually looking for a board observer seat. And I would say it does two things. One, it gives us a view on what's going on in the company so that we can assess valuation, and we can quickly react to add on opportunities or other investments into that company that might come up. But it also gives us a window into how that sponsor manages their portfolio companies. And again, a strong sponsor who is demonstrating in those board meetings, their vision, strategic leadership, guidance, relationships with management, those are groups we want to do more business with. And so in a lot of ways, we think of board meetings as a chance for the sponsor to shine. If they don't, that's obviously telling in itself. Other governance rights, I would say, are more focused on information. There have been situations, particularly with independent sponsors and others for home long term funding is a big questionable where we've said, look, we need a liquidity right after a certain period of time. But that's because we don't really want to get into a situation where that sponsor is making money on management fees on a company they should have sold. We really want to make sure that exits are happening. But generally speaking, a well-capitalized manager who has a decent portfolio and is able to keep raising funds, they're going to sell assets at the right time. What we don't want is somebody sitting on things for a longer time and watching our returns, or at least our IRRs, start to rapidly decline for every last little bit of multiple expansion. And Adam, how do you think about capital that's actually drawn at close first committed capital beyond that? Will you make a commitment and have capital sitting on the sidelines waiting to be deployed into a portfolio company if you're co-investments? Absolutely. We reserve about 10%. Anyways, for most deals, we assume there's going to be follow-on for add-ons or sometimes difficult situations. But if a sponsor has a particular identified growth path that requires additional capital for add-on acquisitions, we're happy to reserve that capital. We'll want to maintain some discretion of how that is drawn usually. We're not big blank check writers, but that discretion is usually freely given to me. And we're all on the same team. And we've already underwritten someone who has shown us that they're pursuing a path that we're excited about. When a co-investment hasn't worked out, is there a typical root cause or is it range in the spectrum? When I think about deals that haven't worked out, they are almost always situations in which-- at least the worst ones-- in which something has happened to the company frequently for exogenous reasons, and the managers made it worse. And those are the most frustrating ones. They're the situations in which things are going really well through a cyclical high. The manager overlevers at the top. And then things start falling apart for operational reasons. We've seen that happen. Or it's when the manager is unable to deal well with banks in a difficult situation with the company's lenders. Or when they have made add-ons that were just way off spec, way off of the industrial logic of the existing company where you're creating assets that I sort of describe as franken assets that are cobbled together, but don't make any sense to anyone. Those are-- I would describe as manager foot faults that become real problems for businesses. When there is a company that hits an exogenous or unexpected-- and maybe a better way of putting that unexpected bump in the road-- generally speaking, good sponsors who are well attuned to the situation and are doing the right kind of work can manage through that. The buyout business, when done right, should be pretty resilient. It's not always and that's when we view manager. error is really the problem. If I think about partners capital and the way that you approach the co-investment market, we talked a little bit about the differentiation you have with the decision making timelines. Is there anything else that you believe genuinely is different from other limited partners or co-investors in the space? Yeah, I think it's related to what you just said, which is we want to act like a small investor with a big checkbook. What's the objective is to be nimble, to be decisive with both junior and senior level decision makers and investors in the room working on deals together who can make decisions decisively and quickly and do so with a large check. What we often see is there are nimble investors who write small checks. There are large check writers who have large bureaucratic processes that can drag out and often result in surprises. We said let's merge the two or take the best of the two, which is to say let's have a surprise free process where senior people are involved all the way through and let's have the capital resources to really make a difference to sponsors so that when they're raising $150 million, let's say in a co-investment that's got to happen pretty quickly and this is a middle-market sponsor, let's say without huge resources to go out and get it done. We want to be 75 of that and we want to get it done quickly and solve your problem. We are recognizing that we need to set up our business in order to reflect that need and that's what we've tried to do. For a sponsor who is not already in your LP base but wants to build towards a co-investment relationship, what's the right first step? Get to know us. We always find that when someone brings us the deal cold, we don't know anything about how they look at deals, what their track records like, where they've done well, where they've struggled, we have a lot of work to do. We have a lot of work to figuring that out and the risk is when they're under a tight time frame, we've got a lot of other things on our desk, we're going to be really frank with them up front and say we cannot spend the time to figure out this potentially complex story because we don't know enough about you right now. If this is a group we know really well and we've spent time together understanding their wins and their losses, their strengths and their weaknesses and we've sat down in our office running theirs or over lunch and gotten to know one another, those conversations are so much easier. So what I'd say is get to know us. We're happy to spend the time up front, no problem at all. We are built to do that. We allocate resources to getting to know folks and building relationships before there's a live deal. So that's where I'd start every single time. Well, Adam, thank you so much for joining me today. I really appreciate your time. Thank you, Matt. I've enjoyed this very much. And Adam, on this part of the episode, we like to ask you a few rapid fire questions if that's all right. That's all right. And now it's time for your quick fire questions. So what book is currently sitting on your bedside table? Flashmins and trouble. And what's that about? Long story, two complex. It's a novel. And I'm going to forget the last name of the author because, of course, I read on Kindle. And so I don't look at the title every morning or at night. It's a Kindle, not a book. It's a Kindle. And it's Taffy who also wrote the Long Island Compromise, which I think is one of the funniest books I've ever read. So this is actually, I think, written before that. It's a very funny novel about a couple in New York City and where I am in the book right now is about 45% of the way through. It's a total mess. And I'm told by my wife who read it before me that it will resolve. What was your first job? First job, I went going way back. My first job was working at a wind surfing store illegally in Cambridge, Massachusetts. I was at the age of 11 sweeping the floors and cleaning up in a wind surf shop. And I would have to go hide when the revenue inspector or the tax collector, whoever would come around, they would often tell me quick in the basement. So that was where it all began. I guess we're past the statute of limitations on that one. So we're probably okay. I hope so. So what are you most excited about as we move towards the end of 2026? What am I most excited about really becomes what am I most hopeful for and what I hope for as an investor, but also as a citizen of the United States? And the world is stability. I think the volatility of the last couple years has made the investment business very difficult and some predictability and stability I would welcome right now. What is one finance buzzword you'd happily retire? Finance buzzword at retire value ad because it's the one I most skeptical of. It's the, and this is very specific to co-investing. Sponsors always are telling us of their value ad. And I think one of the things we always try to pick apart is was it the sponsor or was it the company? Are you an early morning or late night person? Late night. I wish I were a morning person. I admired envy those people, not one of them. And what's the best career advice you've ever received? A for anticipate. When I was a young investment banker, a senior member of my firm where I was working and I'll call his name out because he was an important guy, Hoyd Amadon, Jr. Hoyd one day when I was standing with him on a subway platform, we were going down to a client and I'd been working for something like six months and he said, "Oh, let's make sure we, oh, I wish we had this document." And I said, "Oh, I've got it." I said, "A for anticipate." And it's something I tell my junior and senior staff all the time because what it really is about taking ownership of the work. It's about thinking, not just what have I been told to do, but if I were in the shoes of the senior person or decision maker, what do they really need to make a decision? Because that could be me. And it's going to be me one day. When you're a junior person, you've got to think about that. A for anticipate is something I learned from Hoyd Amadon, Jr. or was recognized for and understood then and still today the power of that concept and tell everybody I know. Well, I know I wasn't as funny as Justin Abelow, but hopefully I did a decent job interviewing you today, Adam. I wouldn't, you know, Abelow would have been too fast for me. All right. Well, thank you. Yeah, thanks, Matt. It was fun. I really enjoyed my time with Adam. I would tell you in terms of my three key takeaways. Transparency is key for private equity managers during the co-investment process. The process can move very quickly. Adam mentioned eight days, but that can only happen if you show him. As he puts it, your works and all. And what that really means is being as transparent as possible when you're digesting information and providing that information to the co-investor. The second is co-investors like Adam are happy to pay for performance. They're happy to pay carried interest. Adam even mentioned super carry, 25% carry over a tier. They're going to tear that as it relates to an IRR and a multiple of invested capital hurdle, but they're happy to pay for performance. The last thing I'd say is the co-investment market has clearly evolved beyond just primary commitments. Adam mentioned he's happy to get to know private equity sponsors early and before they've even made a primary commitment, they're happy to do a co-investment before they've made a primary or secondary commitment. And I would tell you the market has evolved significantly over the last two to three years. Thank you for listening to Capital Revolution. For more insights, visit us at hl.com. If you enjoyed the episode, let us know by leaving the show or rating and review on your podcast platform of choice.