Alternative Insight – November 2015

Out of the shadows: the rise of shadow capital

Shadow capital is on the march. How will it affect the world of private equity?

Shadow capital refers to the practice of institutional investors, family offices and sovereign wealth funds deploying their capital alongside (or even in competition with) private equity funds, but in ways that stand apart from the traditional GP-LP relationship, where the investors place their capital in the hands of a fund manager to invest on their behalf.

The term “shadow” arose because investors often decided against disclosing active investments made alongside PE funds. There is also an alternative sense of investors “shadowing” fund managers in activities that are traditionally considered to be GP territory.
The rise of shadow capital boils down, in essence, to three things: investors are concerned about the detrimental effect of rising costs on returns from their private equity investments; they want increased autonomy as to how and when they invest their money; and they have mountains of cash available to deploy.

Shadow capital can take many different forms, probably the most common of which are:

Co-investments

This is where an LP makes an additional, separate investment into a company alongside the main investment made by a fund in which the LP is itself an investor. Co-investing is by no means a new phenomenon, but it is now very much the norm. While GPs generally prefer to retain discretion over the allocation of such opportunities, most investors want at least to be considered for potential co-investments and major investors sometimes have enough sway to obtain preferential or guaranteed co-investment rights from their GPs.

Direct investments

Some deep-pocketed investors, such as the likes of CPPIB and some sovereign wealth funds, have been building management teams in-house, giving them the technical capabilities and know-how to find, evaluate, manage and sell private investments independently of, and sometimes in competition with, private equity firms. This form of shadow capital is probably the most direct challenge to the conventional PE model.

Managed accounts

A managed account is a bespoke investment account, funded by a single investor and managed by a fund manager selected by the investor. They have long been common in the hedge fund space, but are growing in popularity in private equity too, because they are typically cheaper for investors than an equivalent fund investment, with potentially greater control over the investment portfolio. We examined managed accounts in our February 2015 Alternative Insight.

Direct lending

Partly due to stiffer regulatory requirements, big Western banks are being much more conservative with their commercial lending operations. With a funding gap opening up, some big institutional investors have seen this as an opportunity to provide debt finance directly to businesses.

Opportunities and challenges

The rise of shadow capital has brought with it a number of new opportunities, as well as new challenges, for private equity fund managers and investors alike.

On the plus side:

  • For investors, shadow capital strategies give them greater control over their investment portfolio, usually at lower cost, and thus offer scope to improve returns. They also develop and improve skills, expertise and knowledge on the investment side.
  • When a GP facilitates shadow capital structures like co-investments, it can cement and even expand its LP relationships. This may also encourage existing or new LPs to commit more cash to the GP’s blind-pool funds.
  • An ability to bring shadow capital into deals gives a PE fund significant extra monetary firepower, which can be vital in pipping competitors in the race to acquire highly desirable assets and companies. With shadow capital now a realistic option to bridge this funding gap, a PE fund shouldn’t need to club together with other PE funds in order to take on bigger deals.

Nevertheless, some fund managers have eyed the march of shadow capital with circumspection:

  • It puts pressure on GP income streams. Management fees and carried interest are often lower (or in some cases non-existent) in managed accounts, co-investments and direct investments.
  • Shadow capital adds liquidity to a private-capital market that is already swimming in cash. Dry powder is said to have hit an all-time high (Bain & Company put it at £1.2 trillion in their Global Private Equity Report 2015). The effect is to increase competition for assets and thus acquisition prices.
  • GP-LP relationships can become more strained as investors directly compete with fund managers for a piece of the best deals.

Equally, from an investor’s perspective, returns from shadow capital do not always trump blind-pool investment:

  • Investor portfolios can become less diversified where the investor allocates more capital to fewer opportunities, which therefore carry higher levels of risk.
  • Shadow capital investors are taking on much greater responsibility for investment selection and performance – so they need to have in place the people, know-how and systems to operate in the way that experienced GPs do. It takes time and money to build that.

Conclusion

In order to meet the challenges of shadow capital head on, particularly the peril of direct competition, fund managers need to think innovatively about how to accommodate these investor concerns. A GP’s best assets are the direct-investment expertise and talent of its executives, developed and honed over years. As these skills are not possessed by most solo investors, GPs should capitalise on them as much as possible.

The evolution of shadow capital could well transform the fundamental nature of the GP-LP relationshim . It will be interesting to see how and where the new equilibrium ultimately settles.


 

Alternative Insight is produced by MJ Hudson’s private funds lawyers. We provide expert legal advice to fund managers, other financial sponsors, investors and advisers on the formation, structuring, investment into and regulation of private funds, managed accounts and similar vehicles. Our practice covers the full spectrum of alternative assets, including private equity, venture capital, hedge funds, private debt, real estate and infrastructure. Clients praise our entrepreneurial approach, commercial outlook and dedication to helping them achieve their objectives, regardless of the obstacles.