Investment Pacing in an Expensive Deal Environment

The topic of investment pacing is a sensitive one because it represents that point of friction where classroom theories of portfolio construction meet the complicated realities of managing third-party capital. I like to call it the “Goldilocks Syndrome” because investors want their dollars invested, but not too fast and not too slow – just right. Unfortunately, sponsors trying to execute on quality deals at attractive valuations run into a multitude of challenges that seem to conspire against very predictable deployment of capital (e.g. competition, pricing, diligence issues, etc.). In our experience, proactively addressing why these challenges occur helps discussions with investors.

As many GPs came back to fundraise after the Global Financial Crisis, they were frequently met with LP questions about wide gross-to-net spreads on their returns, longer hold periods for investments and the prudence of an increased fund size given the slower deployment of capital. Sponsors often found themselves playing catch-up in these conversations, dragging out some fundraises unnecessarily as LPs got smart on these issues. Investment pacing is likely to rear its ugly head again in future fundraises given the amount of PE dollars chasing quality opportunities in our market today. It is our view that sponsors should take action with their LPs today to address these concerns, so that their next fundraise doesn’t suffer from the same “learning curve” as the last one.

We are currently in the throes of another Annual Meeting season and this is a smart time for GPs to start the discussion with their investors about capital deployment. Instead of simply walking through the same PitchBook market statistics as everyone else, it would be more impactful for GPs to spend time explaining in which assets or sectors it may make sense to stay competitive on price. As we know, not every 9.0x purchase price multiple is created equal. Specific companies may be worth paying up for and some PE firms have the internal expertise to add value to higher priced companies and continue to deliver attractive returns to LPs.

The “Gap Analysis” or bridge analysis is increasingly being used to positive effect for explaining the difference between current marks and the marks at exit (encouraging LPs to see the upside in underdeveloped portfolios), but it has another less discussed purpose – providing an in-depth explanation of the sponsor’s value creation plan for each asset moving forward. Additionally, the gross-to-net spread that LPs experienced in prior funds can often be mitigated by PE firms through careful use of their capital call lines, improved transaction fee pass-throughs, lower overall management fees (which the market has driven in many cases) and more prudent deployment of capital. Sponsors that take the time to explain how co-investment, reserves for add-on acquisitions and other deployment methods provide a greater percentage of invested capital and reduce fee drag will gain greater support from their LPs moving forward.

In short, bring LPs into the conversation earlier to avoid a slower and more protracted investment process later. Investors value transparency and if sponsors educate them on how they think about investment pacing and what’s driving those decisions, then it will lead to a more constructive dialogue when they next approach the market for fundraising.

Next on 60 Seconds with Sixpoint: Sizing the Middle Market

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