Permanent-capital structures evolve as LPs demand alternatives

Kattegat Trust, a charitable vehicle set up by Teekay Shipping Corp magnate J. Torben Karlshoej, was looking to diversify its portfolio beyond its core shipping holdings. The trust sought exposure to asset classes like private equity by harnessing a broader base of capital from other limited partners.

But instead of forming a traditional 10-year private equity fund to do this, the effort spawned the 2006 initial public offering of Compass Diversified Holdings Inc.

Now reaching a decade as a public company and approaching a market cap of $1 billion, Compass Diversified owns nine middle-market portfolio companies in a holding-company structure with no pressure to sell to boost the performance of a fund.

Instead of private LPs getting 80 percent of the carried interest in its investments as they would in a PE fund, Compass’s public shareholders fill that role. They can stay in as long as they like, or exit by selling their shares in the stock market.

Instead of carried interest, investors receive quarterly dividends derived from operating income and investment gains from the portfolio.

“We have no forced deployment or harvesting of capital, unlike a private equity fund,” Alan Offenberg, chief executive of Compass Diversified, said in a phone interview. “We never acquire a new company and then have a meeting on how we optimize the company for year four or five. That’s just not how we do things.”

Compass Diversified is one example of the different ways LPs with permanent capital are looking to invest. Unlike public pension funds, which may need quicker distributions to fund their retirees’ needs, LPs such as family offices, wealthy individuals and sovereign-wealth funds continue to seek ways to grow their holdings outside traditional PE pools. GPs are meeting these needs in a variety of ways.

“Today, permanent capital is to the asset management industry what green technology is to the energy industry: It’s an emerging field of interest that has become a fixed component of consideration by asset managers looking to the future,” said Christopher Zochowski, a partner at Winston & Strawn who leads a 30-member team offering expertise in permanent-capital structures.

“It won’t replace private investing or private structures, but it’ll certainly play a much bigger strategic role going forward.”

Emergence amid chaos

The need for longer-term investments emerged during the financial crisis when it became more difficult to sell portfolio companies and LPs felt a cash crunch, Zochowski said. Short-term vehicles with defined harvest cycles were then seen as more subject to market events.

“If a [GP] raised money in the early 2000s, your harvest period coincided with the market downturn when financing, and many potential buyers, evaporated,” Zochowski said.

“LPs were trying to get cash from exits and GPs were holding largely illiquid positions at that point. These factors created a serious challenge for the life cycle of many funds and management teams.”

Some also see longer-life funds as a better way to ensure they have capital to deploy during market disruptions, he said.

“When the market goes south, the group with permanent capital is king,” Zochowski said. “If you have permanent capital and can confidently bring it to the table, you will enjoy a critical advantage when potential buying opportunities are at a peak.”

Winston & Strawn’s permanent-capital unit offers a variety of approaches.

“We talk with our clients about what they are trying to achieve,” he said. “We take those answers and apply them across the spectrum of structures that have been done, almost all of which we have experience in, as well as a range of new, evolving structures.”

Frank Angella, managing partner at Grove Street Advisors, which manages about $5 billion for institutional LPs, said the firm has invested in one group and looked at others considering a corporate structure in the vein of Berkshire Hathaway, the holding company controlled by Warren Buffett.

“Groups are going to traditional PE LPs and saying, ‘Let’s have structures where we have a longer investment period, more like unlimited recycle provisions’ and ‘maybe we say in order to allow you to invest, we’ll create an exit structure,’ ” Angella said.

“The intention may be to take the whole thing public as a conglomerate or potentially — in year 15, LPs start to have an annual option to redeem — they’ll hold a put that goes back to the GP, who can then figure out how to buy out an LP. At that point, are the other LPs buying in more, is a secondary purchaser coming in? Or if there are enough LPs who want out, what happens then? So questions still remain.”

Having a capital horizon outside a traditional fund structure can provide an advantage in wooing portfolio companies, he said.

“If you’re able to say to a target, ‘I’m not a private equity flipper with a normal private equity time frame of three to seven years and you’re out,’” he said. “You can appeal to them that it’s longer term. In the end, you may not be that different. You may still choose to exit after an appropriate hold period.”

GPs meeting demand for longer fund lives

Some longer-life-fund specialists out there include General Atlantic, which uses evergreen funds, as well as Golden Gate Capital.

Pivoting toward demand for longer-term vehicles, larger firms such as Blackstone Group have been offering different types of funds such as Blackstone Property Partners, an open-ended fund and the first from the firm to offer quarterly liquidity to investors. They also have the Core Private Equity fund, a $2.5-billion-and-growing pool investing in slower-growing companies for longer hold periods.

“There’s definitely more demand for long-life vehicles than there used to be,” Blackstone COO Tony James said July 21 during the firm’s quarterly press call. “Very successful family offices and wealthy families over the years have had a strategy of investing into great assets, holding them a long time, but not necessarily getting the same IRR. But they get a lot richer over time. And I think a lot of the institutional investors we’re seeing are coming around and are seeing that.”

Brian Gallagher, partner and co-founder of Twin Bridge Capital Partners, said he hasn’t seen many middle-market firms offer longer-life funds to their LPs because of the challenge in finding interim liquidity for these types of vehicles, if needed.

“Investors are pretty reluctant to do very long-term commitments without a way to get to redemptions and liquidity,” Gallagher said. “GPs also have issues. If you have longer-term vehicles, it is not easy to pay carried interest to your investment team without monetization. None of these issues is insurmountable, but they’ve led to not too many firms trying to solve the riddle in the middle market.”

Compass Diversified CEO Offenberg said the company gets calls from other players interested in its holding-company approach.

“We’ve absolutely had conversations with people that are interested in our structure and how it works and how they’d pursue something similar,” he said. “We’re excited about the prospect of others because we think it’ll bring clarity to the marketplace about this structure and what we do.”

As the company marks its first decade this year as a public stock, it’s invested $2.2 billion and paid out nearly $600 million in dividends since inception. It recently added its 17th platform company in its history with the acquisition of 5.11 Tactical, a maker of police gear, for $400 million.

While paths of permanent capital to private markets continue to branch out, the allure of traditional funds remains.

Michael Sonnenfeldt, founder of Tiger 21, an investment group of 440 high-net-worth individuals that manage more than $40 billion, said some businesses actually perform better under the pressure of a five-to-seven-year turnaround in a typical PE fund.

“There’s good and bad elements to permanent capital,” he said. “Funds won’t ever go away because they provide an incredibly valuable function. You need a very specific set of skills and risk tolerance to make direct private equity investments. If you don’t have that skill or risk tolerance but you still want exposure, you’re going to want to find the best funds with the best expertise.”

Action Items: Compass Diversified: http://ir.compassequity.com/; Kattegat Trust: http://www.kattegat.bm/about/default.aspx; Chris Zochowski of Winston & Strawn http://www.winston.com/en/who-we-are/attorneys/zochowski-christopher-m.html; Grove Street Advisors’ Frank Angella: http://www.grovestreet.com/team/frank-angella/

Photo of Chris Zochowski courtesy of Winston & Strawn