The current environment has offered increased opportunities for “mid-life” deals The co-investment deal flow that HQ Capital (“HQC”) has seen so far in 2020 has been consistent in volume to previous years but we have observed a shift towards more “mid-life” transactions, (i.e., companies which the lead sponsor already owns) with the number of “mid-life” deals entering our pipeline tripling so far this year. This trend is largely a function of the COVID-19 pandemic as General Partners (“GPs”) have needed to further capitalize their portfolio companies in order to, (i) manage through the crisis, and (ii) pursue growth opportunities, like accretive add-ons, that may present themselves over the next couple of quarters. This has created an opening for co-investors to provide co-investment capital in these “mid-life” transactions. While traditional co-investments, like co-underwrites and post-close syndications, continue to comprise the majority of our co-investment program, “mid-life” transactions have offered especially compelling risk-return profiles and below we have listed a some of the reasons why:
In “mid-life” transactions, HQC and the financial sponsor(s) with whom we partner have built-in knowledge of the asset. We have insight into company characteristics such as, (i) the performance of the business relative to the original investment case, (ii) management team capabilities and ability to execute the operational roadmap (such as integration of synergistic add-ons) and, given the current market environment, (iii) the impact COVID-19 has had on the business and the market(s) in which it operates. This insight is particularly helpful today, allowing HQC to avoid “mid-life” transactions where additional defensive capital is likely to be required. Ultimately, the GP has very good knowledge of the asset including its key strengths, risks and possible levers for future growth. Recent example: In a “mid-life” transaction completed by HQC in May, a GP that had owned a company for almost two years required additional capital to continue its buy and build strategy. Since the fund that held the investment needed to reserve capital for the other companies in the portfolio, HQC was able to step in and invest alongside a GP that has demonstrated an ability to successfully acquire and integrate add-ons.
Many GPs generally hold their investments at cost for the first year of ownership, which sometimes obfuscates the true performance of the investment. In a “mid-life” transaction, the GP has a current and recent mark-to-market, which we review as part of our diligence process and use to base our initial valuation. “Mid-life” transactions allow HQC to step into embedded value based on the continued growth of the company and / or from expected synergies from a potential add-on acquisition. Additionally, in some “mid-life” transactions, HQC may price or structure the deal in a way that results in an immediate mark-up and strong downside protection. While the objective of our co-investments is to achieve strong riskadjusted returns over the duration of the investment, the ability to mark-to-market sooner is a helpful benefit. Recent example: In a “mid-life” transaction completed in July, HQC stepped into an attractive preferred security that allowed a GP to provide growth capital to a strong performing business that it had owned for three years but in which it was unable to increase its investment due to the company already having the largest exposure in the GPs fund. Based on the current mark-to-market by the GP, HQC was able to enjoy an immediate mark-up and potentially avoid the “J-curve” effect that impacts most single manager direct funds and multi-manager co-investments funds. Additionally, the security that HQC invested in provides strong downside protection.
Given that GP’s have been invested in the underlying asset for one or more years by the time HQC reviews a “mid-life” opportunity, the expected time to exit is often shorter than the typical private equity hold period. As such. “mid-life” transactions have the potential to have shorter durations than traditional co-investment transactions while having comparably strong upside potential. With that said, it is important to ensure that HQC and the GP interests are aligned with regards to exit timing and return.
The current market environment has presented HQC with an attractive set of co-investment opportunities and we will look to continue partnering with top-performing managers in both traditional and “mid-life” deals while crafting portfolios designed to outperform the broader private equity fund market.