CASE STUDY

Mid-Market Buyout Private Equity

Public Pension Plan, Switzerland | Spring 2019

Engagement at a glance

A Swiss public pension plan was looking to invest in a mid-market buyout manager. Preferences: >EUR500m fund size, Fund IV onwards. Returns objectives: 10% - 15% net IRR. They were ideally looking for exposure to three continents (US, Asia, Europe), at least three sectors and more than 10-15 companies. Strong ESG credentials were preferred.

Client-specific Concerns

Although this investor was looking for mid-market buyout, early exploration concluded that it would be appropriate to consider some late-stage growth exposure based on their risk-return tolerance. The geographic and sector remit skewed the search towards the larger end of the fund spectrum. Consequently, a key concern was the extent to which returns were generated from financial engineering and high amounts of leverage among larger companies; this to be avoided from a risk perspective. Lastly, the client needed specific structures in order to make the investment viable in their jurisdiction and sector.

Outcome

  • Sourcing, entry valuations and track record. Given the current top-cycle market conditions it was important to ensure strong sourcing channels, healthy entry valuations and low leverage levels. Certain teams are notably better at sourcing “off-market” deals at more attractive valuations. It was also crucial to assess track records over time/cycles and understand loss ratios in different economic environments. This included analysing how the manager handled underperforming investments to mitigate risks. A significant portion of due diligence focused on value creation levers of portfolio companies and the financial impact of operational improvements, to ensure a detailed understanding of the strategies.

  • Lowering costs and mitigating the J-curve. The 2-and-20 structure has been pretty consistent across time, but a number of managers were prepared to offer management fees below the 2% mark. The late-primary nature of some opportunities also meant that, while headline fees were 2% per annum, the remaining fund life was shorter than usual, reducing the blended fee reduced for the investor. Special attention was paid to ensure that hurdle rates stayed constant and that, if there was any American waterfall structure, adequate investor protections were in place. Alignment of interest was a high priority, not only in the form of GP commits (ranging from the traditional 1-2% to 10%) but also to how that commit was paid (cash, deferred fees etc). The assessment looked at how well carried interest was spread among team members and the vesting period, to ensure continuity.

  • ESG and diversity. ESG analysis has become an essential part of commercial due diligence in private equity; most PE managers at least have an ESG policy even if they are not signatories to bodies like the PRI. Yet some pay lip service while others truly pushed forward ESG agendas. In addition to understanding how ESG criteria fed into due diligence of companies we also looked at internal operational issues such as gender diversity.

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