Investment bank Lehman Brothers is reported to be raising a US$1bn fund that will invest alongside buyout houses by taking minority stakes in businesses. Unlike the buyout funds raised by other investment banks, such as Goldman Sachs, the Lehman fund will not be in competition with its corporate M&A clients, including private equity houses, and therefore may be able to safeguard advisory work.
Goldman Sachs, on the other hand, raised an US$8.5bn fund last year, despite controversy over potential conflicts of interest between the bank’s private equity division and its corporate clients. The bank’s private equity arm was also taken to task by outgoing chief executive Hank Paulson for making hostile bids, such as the failed attempts to acquire ITV and pubs operator Mitchells & Butlers.
Other investment banks, such as JPMorgan Chase and CSFB, have decided to spin off their private equity divisions in recent years. Even though the private equity divisions and corporate finance arms of these banks were kept rigorously separate, with the Chinese walls designed to handle conflicts of interest, the fact that the same bank was involved in both activities generated concerns among corporate clients.
But it is clear that private equity can be a cash generator for investment banks. Goldman Sachs has seen revenues from investing and trading soar and in the first quarter of 2006 revenues were up 65% compared with the year before. The potential earnings from private equity are so great that Goldmans is currently raising another fund.
So it is understandable why Lehman Brothers is raising a fund, but there is uncertainty among some private equity directors about how effective the bank’s co-investment strategy will be, particularly if Lehman’s approach is to seek equity stakes in the transactions it is advising on. “We would prefer our advisers to advise rather than to also have a financial interest in the portfolio company,” says Buchan Scott, a partner at Duke Street Capital.
He adds that co-investment is attractive to Duke Street in cases where the equity investment needed for a transaction is higher than the private equity house would normally stretch to or as a means of risk diversification.
“We do a lot of buy-and-build, which means that after the initial transaction we may need further funds, so it can be good to bring someone in as a co-investor,” he says.
Scott points out that there is little likelihood an investment bank would be seen as a more attractive source of corporate finance advice because it also ran a co-investment fund: “There are a lot of funds out there looking to beef up their fund investment through direct co-investment, not least because as a co-investor you normally avoid paying management fees and often avoid paying carry.”
The big issue, he stresses, when it comes to identifying good co-investment partners is finding institutions that are able to provide the resources needed at the right time. “The challenge with co-investment is the co-investor needs to be able to move quickly and make sufficient resources available in areas like due diligence, so that the transaction can be completed,” says Scott.
Daljit Singh, a partner at law firm Berwin Leighton Paisner, agrees: “I can’t see that having a co-investment fund would give an adviser an edge,” he says, noting that a lot of LPs who invest in private equity are doing so in order to then have the chance to co-invest themselves, because of the lower fees involved. “Why would these LPs invest in a co-investment fund run by someone else and so end up having to pay the normal fees?” says Singh.
Tom Lamb, UK managing director at Barclays Private Equity, says that co-investment does not necessarily remove conflicts of interest. “If the bank is acting for a client selling a business there is a clear conflict of interest if the bank ends up as a co-investor in that business because the suspicion could be that it has steered the deal to a particular private equity house because it knows that house will allow it to co-invest.”
As for such an investment bank using its co-investment fund to try and win advisory mandates with private equity houses, Lamb is unconvinced: “If an adviser came to us and said they would like to be considered for work and, by the way, they would also be interested in co-investment I’d ask them to decide which hat they wanted to wear.”
One of the problematic areas in co-investment, say some private equity directors, is when executives at the bank that is co-investing take personal equity stakes in transactions. This was one of the issues that contributed to the problems of Robin Saunders, the glamorous City whiz-kid who headed West LB’s principal finance arm and who left the company in 2003. Although her departure was mainly down to the loss of €650m on a loan made to German TV rentals company Boxclever, Saunders and her colleagues also came under scrutiny for having built up personal share stakes in companies to which the bank had been lending money.
According to Barclays’ Tom Lamb, there is a moral hazard if co-investment fund executives have a personal share in equity stakes in companies they are advising: “They might be more interested in the performance of the fund than in giving the right advice.”
He adds that some banks have co-investment funds and if they win a debt mandate and like what they see of the target company they may ask for the opportunity to invest. In those cases, argues Lamb, there is less of a conflict of interest although there is still a moral hazard but this can be handled with the right internal checks and balances.
James Stewart, a partner at mid-market firm ECI, agrees that generally speaking it does not offer an adviser extra advantages to have a co-investment fund. “Good corporate finance advice is at a premium and what people are looking for is not just intellectual property but impartiality,” he says.
The main elements a corporate finance house offers in order to win a mandate are awareness of the business sector involved, the individuals in the team and their experience, and the ability to offer a competitive advantage in an auction process.
“To some extent these elements conflict with the adviser taking an equity stake,” says Stewart, adding that anything that clouds the relationship between adviser and client presents difficulties.
On the other hand, there are circumstances when it may make sense for advisers to take equity stakes, he concedes. “I’m not saying advisers should be excluded from investing, but you need a fundamental driver as to why that would be attractive,” says Stewart, adding that one reason could be a client seeking bolt-on acquisitions that an adviser was able to source.
He says: “Perhaps a quid pro quo on the adviser foregoing fees would be to receive an investment in the company but that moves the relationship from fee-based to capital gain-based, which is not necessarily in the interests of the adviser.”
Mike Newell, an associate at law firm DLA Piper, says he can envisage situations in which a client would accept co-investment from an adviser: “If the private equity lead sponsor has bitten off more than he can chew and is looking for extra equity, it might make sense to go to the corporate finance adviser he already has a relationship with to look for co-investment.”
There is an argument that if the equity stake taken by an adviser is small and therefore would not enable them to influence decisions in the portfolio company, then there are fewer conflicts of interest.
“I think as long as the equity stake is modest and is not squeezing out management or institutional investors then I would not see it as a particular issue,” says Christopher Allner, a fund manager at Octopus Asset Management.
He adds that he can understand the rationale behind a client offering advisers a small equity stake in return for foregoing fees: “A lot of the larger transactions are auction driven, which means often high costs and fees, so there’s probably some incentive to transfer some of the fees to equity in the deal, although that would change the relationship and bring up conflicts of interest.”
This question of influence appears to be something that Lehman Brothers are aware of, as news reports claim that they would not be seeking to influence portfolio companies and would not be taking seats on the board.
Nigel Berger, a director at corporate finance boutique New World Corporate Finance, says executives in the lower mid-market do sometime make personal investments in transactions they are advising on.
The way it usually works, he says, is that the executives will agree an advisory fee and then invest some or all of that fee in a “strip” alongside the private equity house. “It’s usually a very small proportion of the equity and, as we go in on the same basis as the private equity directors, it avoids conflicts of interest.
“However, this kind of co-investment is probably easier to do in the lower mid-market, where the number of individuals involved is relatively small, than in larger transactions in which investment banks are advising.”
Rather than creating problems, Berger argues that such arrangements can actually benefit the advice being given: “When you’re putting your own money in it really makes you think hard about the advice you’re giving.”
On the other hand, perhaps those advisers enthusiastic about co-investment should remember that the last time there was significant activity in this area was in the late 1990s dot-com mania, shortly before the bubble burst.
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