As large institutional investors have become more practiced, they’ve designated specialized investment teams to evaluate investment opportunities and oversee allocation of assets. As a result of their seasoning, investors are better-situated to assume a more active role in deploying significant assets, even beyond their own. More active proprietary investing does not, however, signify that large institutional investors have the expertise required to manage portfolio companies or have access to particular attractive deals or markets, so increasing numbers of large institutional investors have teamed with private equity fund managers, who have the expertise and access, to form joint ventures—permanent, legally distinct partnerships through which they can directly deploy capital into an asset and achieve greater flexibility over the timing of the sale of particular assets, for instance, and reduced investment costs.
For private equity managers, at first blush, these partnerships would seem to give investors an inordinate amount of control over an investment and a seemingly irrefutable argument for further reduction of fees that already have been discounted in the current investing climate. A more nuanced review, however, shows that funneling certain deals through a joint venture facilitates more durable relationships between managers and limited partners/co-investors, and, where necessary, can provide an infusion of cash to finance an investment the manager cannot make alone.
Joint ventures between private equity managers and large institutional investors are not without risks, though—from fiduciary concerns regarding allocation of opportunities to regulatory compliance—and managers must consider whether the partnership is right for them, their business and, if applicable, their other investors. This article, the first in a three-part series, discusses the reasons behind the increase in private equity manager and institutional investor joint ventures; the benefits; and best practices for managers to avoid potential conflicts. The second article will explain common joint venture legal structures, regulatory obligations and typical terms negotiated. The third article will examine joint venture exit provisions.
The Joint Venture Trend
Private equity managers utilize joint ventures in a variety of commonplace investing scenarios outside of partnerships with institutional investors. JVs are an effective legal structure through which multiple PE firms can acquire a company or for a PE firm to spin off a portion of a portfolio company’s business. In the context of an investment alliance between a private equity manager and an investor, joint ventures are a partnership—rather than a one-off investment in a fund—formed to purchase a particular asset. Joint ventures offer managers and investors a permanent agreement to purchase, manage and sell assets with a quicker execution time and reduced investment costs, and are distinct from co-investments, which occur alongside the fund, and funds of one.
There are other key differences among the structures as well. Like joint venturers, investors in co-investments typically escape management and performance fees, but they tend to pay ancillary fees. They also tend to have less control over the terms of the co-investment, which are often dictated by the private equity manager and more in line with the fund’s timeframe. Investors in joint ventures, on the other hand, negotiate timing with managers at the beginning of the engagement.
Asset ownership is also a point of distinction. In a fund of one, the investor owns shares in the fund. In co-investments, in contrast, the investor owns shares of an investment, while in JVs, the investor is a co-owner of the assets. JV investors also co-operate the invested assets with the manager.
Siobhan Burke, a partner at Paul Hastings, said that joint ventures are fairly similar to funds of one, but tend to foster a more collaborative relationship between the PE firm and the investor. “Some of this develops because, not only does the investor want to make sure they are making investments that will result in good returns, but they want to have relationships with managers that are more tailored to what they are trying to accomplish. Many institutional investors have significant amounts of available capital that they would like to deploy sooner rather than later, and these joint ventures allow them access to deals where they can deploy the capital and have some influence over the investment.”
As investment opportunities evolve, the more savvy institutional investors are favoring joint ventures over traditional direct investments in private equity funds, said John Caccia, a partner at Skadden, Arps, Slate, Meagher & Flom. “We’ve seen a number of the institutional LPs move away from passive investments toward becoming more actively involved at the product level. Some LPs now have teams that are directly charged with being able to do more of these joint venture deals, which leads to them wanting to be more active in the process. Another issue driving this trend is that the capital needs for some of these investments are very varied and may require follow-on investments, so the typical fund structure may not easily be applied to these arrangements.”
The incidence of joint ventures has increased, at least in part, said Caccia, because investors’ expectations have increased as well. “They want more than returns. Many now have teams that are competent as decision-makers and are not satisfied with simply delegating all decisions to a manager for a fee stream that can be significant in size. These teams may have in some cases been hired to be partners with private equity managers, and they may accordingly think about the economics of the deals differently.”
Another driving force behind the trend in higher rates of PE manager and investor joint ventures, Paul McCoy, a partner at Morgan Lewis & Bockius, said, is that in addition to yielding private equity-like returns, the collaboration does not incur the same level of private equity fees. “Some investors, such as large pension funds and sovereign wealth funds, have skilled teams capable of acquiring assets or participating in a group that owns these assets. If you have that skillset, there is no reason to pay a manager. So, these joint ventures are sort of bridging the gap between investing in a fund and investing on your own without a manager.”
McCoy observed that joint ventures are in some ways an evolution of co-investments. “In these deals, managers bring in strategic partners to do a joint venture where the investor or investors are shoulder to shoulder with the manager, and they have significant rights beyond what a typical limited partner would have.”
Joint ventures are also attractive to large institutional investors because their growing sophistication has not necessarily translated into independent access to opportunities. “While the investment teams at institutional investors may be more sophisticated,” said Blayne Grady, a partner at Akin Gump Strauss Hauer & Feld, “I think the deal flow and deal access is still missing and what they are partnering with the managers to get. The teams can assess and evaluate opportunities, but they aren’t having potential deals presented to them, and it’s the managers using their networks to seek out potential investment opportunities.”
Seyfarth Shaw partner Bob Bodansky noted, however, that despite the increase in the number of joint ventures, there’s a fairly limited pool of investors that have the sophistication, resources and board approval to participate. “These types of deals have been happening with real estate-focused joint ventures for a long time. You’re seeing some of that shift now to the larger players in the broader private equity world.”
Benefits of a Joint Venture
The primary benefit of joint ventures, for both managers and investors, is the economics. By partnering to invest in a company, asset or portfolio, an institutional investor can pay either reduced or nominal fees and receive a percentage of revenues, while a manager may be able to obtain more favorable deal pricing by virtue of being able to execute on deals more quickly.
The Manager’s Perspective
Perhaps the most valuable long-term benefit to managers of a joint venture is cultivation of a strong, and hopefully loyal, relationship with a large institutional investor. “For managers, among the benefits they receive is that they can develop long and deep relationships with some of the key players in the investment world,” said Bodansky.
The quality of that type of strategic and enduring relationship with an investor gives a manager a reliable source of capital, Burke noted. “Having access to capital and developing a relationship with an investor is highly desirable, because they want to make sure they have ready sources of capital when investment opportunities present themselves.”
Access to capital is critical for managers, Grady added. “The manager gets an identified source of capital with pre-agreed terms, including the economics of the deal and the approval process. It allows for faster deal execution with capital they know is interested. That’s a huge benefit to managers.”
The ability to expand into a new market or strategy is another benefit to managers, Rockas pointed out. “If a manager is looking to expand its product offerings, it may look to form a joint venture with an investor that has expertise in that area or has access to particular companies and potential deals.” Managers also partner with investors where they seek to dilute or distribute their concentration in particular assets, noted McCoy.
Finally, observed Caccia, emerging managers, in particular, may benefit from joint ventures with investors. “I’ve seen deals where managers may be looking to target certain asset classes or geographies, but they won’t be able to displace or compete with the mature managers that are already active in the asset class, and so instead they partner with them and share in the economics.”
The Investor’s Perspective
Access to deals is among the most common reasons investors enter into joint ventures, but the favorable economics the partnership can yield tend to be determinative. The partnership generally eliminates traditional management and performance fees, at least on the venture’s investments. “The institutional investor community sees these deals as a way to reduce the overall fees they bear and take a more active position with their investments,” McCoy said. “There is often no fee and no carry on the piece the investor contributes.”
Bodansky observed, “There has been a real push to reduce fees for the larger investors, and the fees are lower than they have been in the past. That was part of the impetus behind the co-investment craze, and it is a part of the impetus behind this one. The lower fees in some of these deals have boosted returns, but investors want to boost returns even further. With a number of these joint ventures, sponsors bring the technical expertise and are paid a fixed fee for services as opposed to getting a traditional management or incentive fee.”
Investors also prefer the control they have over the investment process, including when buying or selling an asset, and the full transparency joint ventures provide. “The investors have the ability to see what the sponsor is doing and confirm that budgets and management as outlined in the agreement or approved by the investor are proceeding in the way that it was agreed it would be done,” said Bodansky.
Characteristics Investors Seek in a Joint Venture Partner
Investors generally look for partners with experience in particular deals, markets or asset classes, or partners with a successful business with interests aligned with the investment.
According to Caccia, the characteristics investors look for in a JV partner can vary based on the deal. “For example, if the investor is looking to get into U.S. infrastructure, investments in this area are going to be significantly influenced by the largest industry players on the GP and LP sides, and so investors may seek to partner with those groups that are best able to access the deal flow. Investors want to partner with the groups that will allow them to access deals, increase capacity or expand into new geographies, and they may also focus on groups that offer specialization in these areas. What the investor is looking for is very much defined by the industry and the type of joint venture the LP is interested in.”
How Managers Can Avoid Potential Conflicts of Interest
It’s vital for managers participating in joint ventures with investors to avoid potential conflicts with other funds the manager offers. “Managers need to absolutely ensure that they have allocated the full investment size to their funds first and foremost,” advised McCoy. “You have a fiduciary duty to your fund and the investors therein. You need to make sure there is not a challenge in hindsight as to your motives for entering into a joint venture to do a deal.”
He added, “The next concern for managers is to be sure these opportunities are allocated fairly. Your reasons have to be sound for why you presented this investment to one investor over another.”
Burke agreed managers must carefully manage the potential conflicts joint ventures present. “If the manager has pooled vehicles and then enters into a joint venture for certain opportunities with a particular institution, the manager has to think about conflicts it may have with commitments to other investors. Customarily, in private equity structures, managers have requirements that they cannot be involved in marketing another fund that has a substantially similar investment strategy for a certain period of time or until a certain percentage of the fund’s capital has been invested. So managers have to consider whether what they are doing with this joint venture would create a conflict with other funds and the manager’s obligations to investors in other vehicles.”
She added that when opportunities to invest the capital present themselves, “The manager needs to consider whether there are multiple buckets from which to draw the investment dollars and how the opportunities are allocated among the manager’s vehicles, such as pooled investment funds or other joint ventures. Allocation is an issue that must be considered.”
Grady advised managers to have very well-articulated allocation policies if they intend to participate in joint ventures with investors. “One of the big drawbacks for managers is that deal flow gets siphoned off from other vehicles. As a manager, what you want to do is set up these joint ventures in a strategy that is either not covered by your existing funds or is set up prior to any existing fund with a similar strategy.”
Grady added that managers also need to anticipate questions from investors outside of the joint venture. “If a large investor has entered into a joint venture with a manager, the manager may get questioned by other large investors about why they weren’t included in the arrangement or one of their own.”