Ready for action

The ability to scale up and down the deal size spectrum through co-investment allows for the pursuit of attractive opportunities in an uncertain market, says MiddleGround Capital’s Mandy Kamm

How would you describe the level of co-investment appetite that you are seeing today and what is driving that demand?

We have seen strong demand from our LP base to co-invest in our platform transactions. In 2022 we deployed over $450 Million of co-invest across 4 platform investments. Our investors like co-investment because of the diversification and favourable economics that it brings. For that reason, we committed at the outset of our firm to offer at least 30 percent of the total equity in each of our deals to co-investment with no fees attached for our fund investors. Over 80 percent of our LPs have taken advantage of this programme.

Of course, we have a broad range of investors in our funds with different degrees of co-investment capabilities. Some are highly sophisticated asset managers with dedicated co-investment teams, which can quickly review materials and make decisions. At the opposite end of the spectrum, we also have groups that aren’t staffed up to the same extent. To accommodate these investors in our Fund II, we created a separate vehicle where they can take advantage of the co-investment economics without having to make a decision on each deal.

Why have you decided to go down this route? Why does co-investment make sense for your programme?

Co-investment has always been a critical piece of our strategy because it deepens the relationship with our investors while enabling us to scale up for transactions that would not traditionally be a fit for our funds due to the equity investment required. By maintaining a modest fund size, we can still play in the lower end of the market to capitalize on some of the inefficiencies and complexities inherent in smaller businesses, then we can scale up with co-investment to tackle larger transactions if the deals align with our strategy. We could raise a larger fund to pursue those larger opportunities, but then the smaller deals aren’t meaningful to the fund anymore. We believe there are opportunities at both ends of the spectrum and we don’t want to be beholden to a certain size of deal based on the amount of capital we raise in our fund. Our ability to identify transactions where our operational focus gives us an opportunity to create values where other may not is our secret sauce, so as long as we are able to underwrite an actionable value-creation plan that drives 25% or more of the equity value created during our ownership, and the management team and operating team have the capacity to implement it, we want to be able to pursue those opportunities regardless of whether they require a $20 million equity cheque or a $350 million equity cheque. By broadening our funnel, we have been able to capitalise on some of those market opportunities that we are well suited to navigate due to our operational backgrounds and industrial expertise.

For example, during covid, we identified a number of compelling opportunities in the automotive space where we could take advantage of industry trends and macro uncertainty during the pandemic. We acquired two businesses where their capital structures were challenging and they required a partner to provide both capital and operational expertise to position the business to take advantage of growth opportunities tied to some trends that we believed were differentiating. These deals required large equity cheques that, based on the size of our fund, would have been too large for us to execute without co-investment. Our LPs, understood the unique advantage that our operational expertise provided in these situations and we were able to leverage co-investment to complete both of those deals during that period. Either investment would have represented nearly 40 percent of our Fund. Co-investment  also allowed us to minimize the debt necessary to complete the transactions, increasing certainty of close while not overburdening the business with servicing debt during a period of uncertainty. Each deal completed during covid was funded by more than 70 percent equity.

One of the strengths to having a team with extensive and focused experience is that we generate more than 25% of our equity return from the operational execution of the items we identified in our Value Creation Plan (“VCP”). For every dollar of equity we can create through the VCP, that’s one less dollar we are relying on leverage to create the return. This enables us to burden our investments with less debt than many of our competitors. During times when the availability of debt financing is limited and/or the pricing is rising due to macro-economic factors, we can consistently put capital to work while other firms are not able to create sufficient return or are uncomfortable with the operational risk. Maintaining access to co-investment during these situations is critical to our investment strategy.

How important is co-investment in terms of primary fundraising?

As a former LP, I know that a lot of firms offer co-investment as a mechanism for fundraising, but I question how many of them deliver on that commitment. We have consistently offered co-investment on every single deal. We have delivered $1.2 billion of co-investment opportunities, across 14 platform investments in our two main funds. Effectively that equates to a 1:1 co-investment dollar to fund size ratio. Our LPs appreciate that we are offering co-investment on every deal, mitigating adverse selection concerns that are often prevalent with co-investment.

What are some of the biggest challenges LPs face when it comes to executing on co-investment opportunities?

The timeline is one concern we hear often. The first question asked during a co-investment process is – “how quickly do we need to decide?” With so many co-investment repetitions, we have streamlined the process and made it easy for our investors to navigate. Most of our co-investment is with existing fund investors who don’t need to re-underwrite us as a manager or even the deal. Our process allows investors access to our deal teams, materials, and diligence in real time. Transparency is essential to get investors aligned with our strategy making it easy for them to get commitments from their investment committees.

In addition, because our strategy is so focused, it is straightforward for the investors to understand our ability to create value. LPs generally find it easier to co-invest with a sector specialist for that reason.

Are you exclusively offering co-investment to existing investors, or do you also use co-investment as a way of engaging with prospective LPs?

Existing fund investors always get priority access for co-investment. We make the investment available on a first come, first served basis, and there is no cap on how much they can invest. We have some investors that are only interested if the investment is above a certain threshold, for example $50 million. These investors primarily focus on our larger transactions. Other investors invest smaller amounts alongside every deal that we do. We always try to accommodate the requests of our investors.

We do have groups that adjust their activity based upon internal portfolio construction conditions. We offer so much co-investment that LP’s can reach GP concentration limits, which means they are temporarily unable to invest more with us until they complete more transactions with other managers. Based on timing and anticipated liquidity events from previous investments, LPs can have other internal issues that may prevent them from making investments. In those situations, we look to build relationships with investors that aren’t currently invested in our fund. This can be an effective way for investors to interact with our team, to observe how we underwrite investments and become familiar with us as a manager outside of a formal fundraising process.

In today’s market, these investors have the appetite to see co-investments but the conversion rate is lower. Many investors are prioritizing making co-investments with their existing GP relationships. The trend over the last few years is that managers are coming back to market quicker and certain investors don’t have the capacity to add new relationships to their pipeline. That said, we continue to actively engage and convert new relationships and believe it is a great way for us to build relationships off cycle. We have had a number of groups that have co-invested with us to establish a relationship and then are first closers into our next fund as LPs.

How is the current macroeconomic situation is impacting demand or supply and how do you expect co-investment to evolve within the private equity industry going forward?

Our LP base is still active making co-investments. Our investors appreciate that, in an uncertain market, we are highly selective, structuring our investments conservatively, and our operational capability provides MiddleGround with a lever for creating equity value that other firms don’t possess. When something unexpected happens at one of our portfolio investments, MiddleGround has the resources and operational abilities to manage and operate the investments.

Historically, there have been more private equity deals being completed than LPs could possibly keep up with, which enabled investors to be highly selective of the managers they invested with and the investments completed. We are now faced with very different market conditions. Deal execution is slowing, which creates less co-investment opportunities for investors.

MiddleGround believes this market is an opportunity. We will complete four platform investments in 2022, offering co-investment on each. We expect to see additional interesting opportunities emerge in the months to come, just as we did during covid. Being able to flex the size of deals that we execute through our co-investment program, has and will continue to be critical for us being active in 2022 and we expect that will continue into 2023. While many other  managers are attempting to wait out market uncertainty and not engaging in deals, we, alongside our co-investment partners are ready for action.

Mandy Kamm is Managing Director, Head of Fund Operations at MiddleGround Capital