Podcast: The New Rules of Co-Investing

[00:00:00] Adam Spence You know, it will be, not apocalypse, no. It will get some, but it won't get them all. And we're believers that many of these groups are gonna come out of this stronger, frankly.

[00:00:13] Matt Swain Welcome to Capital Revolution, the podcast that brings you to the table for the conversations you won't hear anywhere else in the alternative capital market. Adam Spence is a partner head of co-investments and head of the New York office for Partners Capital. He sits on the firm's private equity and real estate and private credit asset class investment committees. Adam spent 13 years at American Capital as a direct investor in private equity in private credit. Earlier in his career, he was a real estate direct investor and an M&A investment banker. Immediately prior to joining Partners Capital in 2018, Adam served in the New York State Governor's Office and was an advisor to foundations and the TPG growth and rise funds. Founded in 2001, Partners Capital is a global investment office with over 75 billion dollars in assets under management. The firm partners with distinguished endowments and foundations, senior investment professionals, and prominent families across the globe to construct customized investment portfolios for its clients across all major asset classes. Adam, thank you for joining us today.

[00:01:21] Adam Spence Thank you, Matt, for having me. I'm glad to be here.

[00:01:24] Matt Swain We're gonna go ahead and jump into some questions, but can you give us a brief overview of Partners Capital's co-investment program? How large is it? How long has it been running? And what role does it play within the broader strategy of Partners Cap?

[00:01:37] Adam Spence Sure, so our first co-investment, and I'm gonna focus today on private equity co-investments because that's a lot of, that's the largest part of our co-invest program, although we do have a program really started about 17, 18 years ago when we did our first co-investment deals with managers with whom we had a fund commitment. Those deals at that time, I describe often as a bit of a pass-the-hat situation. They were not out of a fund. They were with managers we knew very well, generally fairly small ticket sizes. There was high conviction in both the manager and the deal. I came here in 2018 as part of a, I would describe as an in earnest launch of a larger private equity co-invest program. At that time, we raised our first dedicated discretionary co-investment pooled vehicle. That was what we called the beginning of our Merlin series, Merlin I. That was in 2019 with 150 million dollars of committed capital. And since that time, we've now raised four funds. Our fourth fund, Merlin IV, closed late last year at a billion dollars.

[00:02:52] Matt Swain So you talked a little bit about structure. Maybe you can give us a sense of the check sizes that you're looking for today and the type of deals that you are investing in. And what is the range depending on the manager?

[00:03:03] Adam Spence Check size is something that we take a fairly broad view on and that's really a reflection of the many sources of capital who we represent to invest in deals. So in any given deal, we might be investing on behalf of our Merlin IV vehicle. We might be investing funds from our Condor fund to funds or private equity funds pooled vehicle. We might be investing from registered vehicles or other evergreen products. We might be investing for clients who come in directly into deals. And all of these have different size parameters, different speed parameters in some cases. I mean, mostly with respect to some of the direct clients coming in. And so we're really nimble across all of those different sources of capital. So we might be doing some five, 10, 15 million dollar growth equity investments. We might be 10 to 20 million dollar buyout co-investments in smaller deals, or frankly even just smaller checks in larger deals. And then we are frequently and probably most frequently investing really 75 to 85 million dollar sort of core ticket size into private equity buyout co-investments. In those, I'd say the enterprise value of those deals is right now running at an average of about 450 million dollars. So we tend to be a large check into a relatively small deal, though we also invest sometimes in multi-billion dollar companies. It is a very open-ended mandate with respect to size. We are much more focused on what I describe as a company profile than say manager size, enterprise value, et cetera.

[00:04:47] Matt Swain With that, are there core sectors you're looking at currently?

[00:04:50] Adam Spence You know, we're spending a lot of time, like everybody, probably in aerospace and defense right now. We're looking at oilfield services increasingly, and we do quite a bit in industrials. We always have. We are wondering whether there's a bottom soon on software. We do have some view that software feels a bit oversold, that there's baby out with the bathwater situation going on across a lot these. Now, I'd say we're in a monitoring situation on software.

[00:05:21] Matt Swain So you're not necessarily a believer in the SaaSpocalypse.

[00:05:24] Adam Spence You know, it will be, not apocalypse, no. It will get some, but it won't get them all. And we're believers that many of these groups are gonna come out of this stronger, frankly.

[00:05:33] Matt Swain And do you have a target number of co-invest that you're looking to hit, or is it really opportunistic and then it depends on your sizing?

[00:05:41] Adam Spence I'd say we're staffed to do 15 to 20 private equity co-investment deals a year. Doesn't mean we have to and there are years where we do 12 or 13 and there are years where we do, you know, more than 20. So it really has to do with our staffing levels. We have about 350 plus deals coming in every year and that's pretty consistent. It's grown a bit over time but if you think of us as sort of I don't know 325 to 375 new opportunities every year. We have a team that culls through that and prosecutes, call it an average of 15.

[00:06:13] Matt Swain To that effect, how much lead time do you need from that first outreach or first launch as you just put it to an actual commitment?

[00:06:21] Adam Spence So I think the fastest we've ever moved from, I don't know about a launch, but a teaser, so let's say, to a deal preview, probably a little better than a teaser to a commitment was eight days. And I can't say we're gonna do that all the time, but there was a situation where that happened. We're structured internally to deliver certain commitments as fast as we can while still getting the right work done. Because we feel that's a huge differentiator in co-invest land. The reality is, and we hear this all the time, and I'm sure you do, the greatest complaint we hear from sponsors is, there are a lot of people who say they co-invest, but very few of them actually get it done. And I think we heard that first, 10 years ago, whenever it was, and said, let's win on that. I mean, that in itself is in some ways not that hard. It means that we have set up our team, our diligence process and our investment approval process to be, I always resist the term ad hoc because it sounds a bit loose, but I would say it is on call. We can bring our team together at any moment, get through the materials, make a decision. We are sitting together, we are looking at deals together all day long. So when we really like something, we're moving on it right away. Because we know that raising capital is a huge burden on the sponsor or frankly on the intermediary who's supporting them. Everybody wants to get this deal done and get back to focusing on due diligence, managing the business and not necessarily bringing a huge number of parties through a capital raising process.

[00:08:02] Matt Swain I mean, on that note, do you see a larger macro trend taking effect where you're actually going to have more deal flow on the co-investment side? From our seat, we're seeing blind pool capital, you know, that is harder to raise across the board. And we think the co-investment market directs market is just going to continue to grow. Is that what you're seeing as well?

[00:08:19] Adam Spence Yeah, we've seen that. The way we've seen it, and it's related to what you're describing, is we see more deals from more sponsors, which is to say that the number of sources has increased. Five, 10 years ago, not every manager or sponsor used co-investment, and now not every single one does, but many more do. And they're using it more frequently. And I think it's two things. One, it's they've been listening to their investors, both existing LPs and prospective LPs. And two, they realize that raising capital is hard and it's gotten a lot harder in the last few years. And one of the ways you get the attention of an LP or prospective LP is to show them a deal that you're working on, bring them in, bring them very close. And I can tell you when we're working on a deal with a strong sponsor, we see the work they're doing. We recognize it as differentiated, as thorough. Well-considered and we see their investment decision making process much better than we can when we're evaluating. If you can move quickly and be a good partner, it could work well for both of us.

[00:09:27] Matt Swain You talked a little bit about the teasers that you first see in order to move. I mean, what is the ideal co-investment pitch or package of information that you receive from first glance?

[00:09:37] Adam Spence We really want to see, I mean, you know, we're always going to see a teaser, a one or two page teaser that tells a story great, really important. You know, lets us flesh out industry questions, some historic financials, who the sponsor is, where we think this is going. The next phase is that, you know, call it 40, 50 page presentation. Best if that's their internal investment committee work. Fine if it's a more created for external document in itself. I'd say the most important thing at this stage is, show us the whole story. Warts and all, as we say, right? Don't just bring us a sanitized version that's then gonna allow for surprises three weeks, four weeks down the line when you say, oh yeah, I forgot to tell you that margins have been declining on this major customer or the concentration is actually, three customers are actually the same purchaser. The kinds of issues that we ought to know upfront. And frankly, if we're working with a sponsor who is really smart and sees something really interesting in a deal, we're all ears as to why a risk is mitigated, as to a challenging growth opportunity is realistic. Bring us in on that. Treat us like a partner and we'll act like one.

[00:10:57] Matt Swain How do you think about meetings with management? Do you actually have to have a cut deeper in order to meet with the management team or is it more focused on the sponsor themselves? Or is it a give and take depending on the deal?

[00:11:09] Adam Spence Yeah, we like to meet management, but I can tell you we don't always have the opportunity to. So we've had to make a process decision here to say that's a nice to have, but not a must have. There are co-investors out there for whom it is a must have. We made a decision early on and it's been okay. Our results reflect the sanity of the decision, if you will. That the management meeting is something that we need at some level to be relying on our sponsor partners to really make decisions around. We are behind the sponsor we know in so much information flow. That relationship is critical. Now our due diligence process of course validates what we are being told or hopes to validate doesn't always, right? But hopes to validate or verify what the sponsor is telling us. If that sponsor is not making a good decision around management. We've got much bigger problems. We need to be figuring that kind of thing out about the quality of their work and their decision making. And then most importantly, how that sponsor manages management. One of the things we're very wise to, and we've been in this business a long time, is very frequently the management team is replaced post-closing anyways. So we're not really a management first investor. Because we recognize the sponsors we work with very frequently will make a decision to make a change there.

[00:12:37] Matt Swain You talked a bit about transparency. I mean, what are the common mistakes GPs make when they're actually bringing you a co-investment directly?

[00:12:45] Adam Spence It's a bit, as I mentioned earlier, it's that sense of hiding the ball. Don't hide the ball, that's the number one piece of advice.

[00:12:52] Matt Swain Show your warts and all.

[00:12:54] Adam Spence And then the other one is be responsive and be transparent when we ask for data cuts of, you know, I mean, we frequently are looking for margin by customer, margin by product, gross margins usually. Show us that. Help us get under the hood. And frankly, if you haven't done that kind of work, we're going to be worried because we view that kind of work generally as critical. We've seen channel stuffing and we've seen other tactics by sellers that some basic diligence blocking and tackling can illuminate and sponsors who are not doing that kind of work, we probably shouldn't be doing business with.

[00:13:30] Matt Swain How do you think about fee and carry in these type of co-investments? And do you have an expectation, depending on whether you're a primary investor or whether you are just meeting the manager for the first time?

[00:13:42] Adam Spence Yeah, when we're an LP in a fund and committed to that fund, we expect fee-free, carry-free deals. That is built into the pricing model of a fund commitment. That's built into that relationship from day one. About 60 percent of the deals we've done in the last 12 months have been outside of our relationship base, which is to say with sponsors with whom we do not have a fund commitment. We recognize that for some of those sponsors, they need to make a living. They need to keep the lights on and they rely on some kind of income stream to do that and incentive through carry. We generally do not pay, we almost never, we have not paid management fees in a long time. We look for sponsors to draw some monitoring fee from the portfolio company. We're okay with that. We do generally look for a cap on that. We don't want that to be a source of a profit center, really, but understand that that's a way to keep the lights on. We are open to paying carry to sponsors with whom we do not have a fund relationship. The smaller they are, the more we're open to that.

[00:14:51] Matt Swain And do you usually have a multiple of invested capital tied to that or is it really just an IRR?

[00:14:55] Adam Spence No, we like to have both because we recognize duration varies by manager. We want to see multiples over two times. We want to see IRRs over 20 percent, target at least. I mean, we recognize not everything gets there, but those hurdles are critical and they really are an area where, again, we're happy to pay for performance and we've paid 25 percent carry over higher hurdles in the past. It's not that the percentage sharing is small, but the hurdle matters a lot.

[00:15:23] Matt Swain And how do you think about governance and information rights? Are you typically looking for a board observer seat, specific reporting rights? I mean, any protective provisions as it relates to just information?

[00:15:34] Adam Spence I think we have board observer seats on eight of our 10 last deals. And those are situations, let me differentiate the two where we don't, are very large transactions where our 50 or 70 million dollars is not a big number. But if we're 25 percent or more of a co-investment raise, we're usually looking for a board observer seat. And I would say it does two things. One, it gives us a view on what's going on in the company so that we can assess valuation and we can quickly react to add-on opportunities or other investments into that company that might come up. But it also gives us a window into how that sponsor manages their portfolio companies. And again, a strong sponsor who is demonstrating in those board meetings their vision, strategic leadership, guidance, relationships with management, those are groups we want to do more business with. And so in a lot of ways, we think of board meetings as a chance for the sponsor to shine. If they don't, that's obviously telling in itself. Other governance rights, I would say, are more focused on information. There have been situations, particularly with independent sponsors and others for whom long-term funding is a bit questionable where we've said, look, we need a liquidity right after a certain period of time. But that's because we don't really want to get into a situation where that sponsor is making money on management fees on a company they should have sold. We really want to make sure that exits are happening, but generally speaking, a well-capitalized manager who has a decent portfolio and is able to keep raising funds, they're going to sell assets at the right time. What we don't want is somebody sitting on things for a longer time and watching our returns, or at least our IRRs, start to rapidly decline for every last little bit of multiple expansion.

[00:17:25] Matt Swain And Adam, how do you think about capital that's actually drawn at close first, committed capital beyond that? Will you make a commitment and have capital sitting on the sidelines, waiting to be deployed into a portfolio company of your co-investments?

[00:17:39] Adam Spence Absolutely. We reserve about 10 percent anyways for most deals. We assume there's gonna be follow-on for add-ons or, you know, sometimes difficult situations. But if a sponsor has a particular identified growth path that requires additional capital for add-on acquisitions, we're happy to reserve that capital. We'll want to maintain some discretion of how that is drawn usually. We're not big blank check writers, but that discretion is usually freely given. I mean, we're all on the same team and we've already underwritten someone who has shown us that they're pursuing a path that we're excited about.

[00:18:15] Matt Swain When a co-investment hasn't worked out, is there a typical root cause or is it range in the spectrum?

[00:18:23] Adam Spence When I think about deals that haven't worked out, they are almost always situations in which, or at least the worst ones, in which something has happened to the company, frequently for exogenous reasons, and the manager's made it worse. And those are the most frustrating ones. They're the situations in which things are going really well through a cyclical high and the managers over-levers it at the top, and then things start falling apart for operational reasons. We've seen that happen. Or it's when the manager is unable to deal well with banks in a difficult situation with the company's lenders, or when they have made add-ons that were just way off spec, way off of the logic, industrial logic of the existing company, where you're creating assets that I sort of describe as frankenassets that are cobbled together, but don't make any sense to anyone. Those are, I would describe as manager foot faults that become real problems for businesses. When there is a company that hits an exogenous or unexpected and it may be a better way of putting that unexpected bump in the road, generally speaking, good sponsors who are well-attuned to the situation and are doing the right kind of work can manage through that. The buyout business when done right should be pretty resilient. It's not always and that's when we view manager error is really the problem.

[00:19:59] Matt Swain If I think about Partner's Capital and the way that you approach the co-investment market, we talked a little bit about the differentiation you have with the decision-making timelines. Is there anything else that you believe genuinely is different from other limited partners or co-investors in the space?

[00:20:16] Adam Spence Yeah, I think it's related to what you just said, which is we want to act like a small investor with a big checkbook. That's the objective is to be nimble, to be decisive with both junior and senior level decision makers and investors in the room, working on deals together, who can make decisions decisively and quickly. And do so with a large check. What we often see is there are nimble investors who write small checks. There are large check writers who have large bureaucratic processes that can drag out and often result in surprises. And we said, let's merge the two or take the best of the two, which is to say, let us have a surprise-free process where senior people are involved all the way through. And let's have the capital resources to really make a difference to sponsors. So that when they're raising 150 million dollars, let's say in a co-investment, that's gotta happen pretty quickly. And as a middle market sponsor, let's stay without huge resources to go out and get it done. We wanna be 75 of that and we wanna get it down quickly and solve your problem. We are recognizing that we need to set up our business in order to reflect that need and that's what we've tried to do.

[00:21:38] Matt Swain For a sponsor who is not already in your LP base, but wants to build towards a co-investment relationship, what's the right first step?

[00:21:47] Adam Spence Get to know us. We always find that when someone brings us a deal cold, we don't know anything about how they look at deals, what their track record's like, where they've done well, where they have struggled. We have a lot of work to do. We have lot of to figuring that out. And the risk is, when they're under a tight timeframe, we've got a lot other things on our desk, we're gonna be really frank with them up front and say, we cannot spend the time to figure out this potentially complex story because we don't know enough about you right now. Now, if this is a group we know really well and we've spent time together understanding their wins and their losses, their strengths and their weaknesses, and we sat down in our office or in theirs or over lunch and gotten to know one another, those conversations are so much easier. So what I'd say is get to know us. We're happy to spend the time upfront, no problem at all. We are built to do that. We allocate resources to getting to know folks and building relationships before there's a live deal. So that's where I'd start every single time.

[00:22:49] Matt Swain Well, Adam, thank you so much for joining me today. I really appreciate your time.

[00:22:54] Adam Spence Thank you, Matt. I've enjoyed this very much.

[00:22:55] Matt Swain And Adam, on this part of the episode, we like to ask you a few rapid fire questions if that's all right.

[00:23:01] Adam Spence That's all, right.

[00:23:03] Matt Swain And now it's time for your quick fire question. So what book is currently sitting on your bedside table?

[00:23:14] Adam Spence Fleishman is in Trouble.

[00:23:14] Matt Swain And what's that about?

[00:23:15] Adam Spence Long story too complex it's a novel and I'm gonna I'm going to forget the last name of the author because of course I read on Kindle and so I don't look at the title every morning or.

[00:23:25] Matt Swain It's Kindle not a book?

[00:23:26] Adam Spence It's a Kindle, and it's Taffy who also wrote the Long Island Compromise which I think is one of the funniest books I've ever read so this is actually I think written before that. It's a very funny novel about a couple in New York City and where I am in the book right now it's about 45 percent of the way through. It's a total mess. And I'm told by my wife who read it before me that it will resolve.

[00:23:49] Matt Swain What was your first job?

[00:23:51] Adam Spence First job, I've been going way back. My first job was working at a windsurfing store, illegally, in Cambridge, Massachusetts. I was at the age of 11, sweeping the floors and cleaning up in a windsurfer shop. And I would have to go hide when the revenue inspector or the tax collector or whoever would come around, they would often tell me, quick, in the basement. So that's where it all began.

[00:24:13] Matt Swain I guess we're past the statute of limitations on that one, so we're probably okay. I hope so. So what are you most excited about as we move towards the end of 2026?

[00:24:24] Adam Spence What am I most excited about really becomes what am I most hopeful for and what I hope for as an investor, but also as a citizen of the United States and the world is stability. I think the volatility of the last couple of years has made the investment business very difficult and some predictability and stability I would welcome right now.

[00:24:49] Matt Swain What is one finance buzzword you'd happily retire?

[00:24:52] Adam Spence Finance buzzword I'd retire. Value add, because it's the one I'm most skeptical of. And this is very specific to co-investing. Sponsors always are telling us of their value add. And I think one of the things we always try to pick apart is was it the sponsor or was it that company?

[00:25:11] Matt Swain Are you an early morning or a late night person?

[00:25:14] Adam Spence Late night. I wish I were a morning person. I admire and envy those people, not one of them.

[00:25:21] Matt Swain And what's the best career advice you've ever received?

[00:25:25] Adam Spence A for anticipate. When I was a young investment banker, a senior member of my firm where I was working, and I'll call his name out because he's a, because he was an important guy, Hoyt Ammidon, Jr. Hoyt one day when I was standing with him on a subway platform. We were going down to a client and I'd been working for something like six months and he said, Oh, let's make sure we oh, I wish we had this document. And I said, Oh, I've got it. I said A for anticipate. And it's something I tell my junior and senior staff all the time, because what it really is about taking ownership of the work. It's about thinking not just what have I been told to do, but if I were in the shoes of the senior person or decision maker, what do they really need to make a decision? Because that could be me, and it's going to be me one day. When you're a junior person, you gotta think about that. A for anticipate is something I learned from Hoyt Ammidon Jr. or was recognized for and understood then and still today the power of that concept and tell everybody I know.

[00:26:33] Matt Swain Well, I know I wasn't as funny as Justin Abelow, but hopefully I did a decent job at interviewing you today, Adam.

[00:26:39] Adam Spence I wouldn't, you know, Abelow would have been too fast for me.

[00:26:43] Matt Swain All right. Well, thank you.

[00:26:45] Adam Spence Thanks, Matt. It was fun.

[00:26:48] Matt Swain I really enjoyed my time with Adam. I would tell you in terms of my three key takeaways, transparency is key for private equity managers during the co-investment process. You know, the process can move very quickly. Adam mentioned eight days, but that can only happen if you show him, as he puts it, your warts and all. And what that really means is being as transparent as possible when you're digesting information and providing that information to the co-investor. The second is co-investors like Adam are happy to pay for performance. They're happy to pay carried interest. Adam even mentioned super carry, 25 percent carry over a tier. They're gonna tier that as it relates to an IRR and a multiple of invested capital hurdle, but they're happy to pay for a performance. The last thing I'd say is the co-investment market has clearly evolved beyond just primary commitments. Adam mentioned he's happy to get to know private equity sponsors early and before they've even made a primary commitment. They're happy to do a co-investment before they've made a primary or secondary commitment, and I would tell you the market has evolved significantly over the last two to three years. Thank you for listening to Capital Revolution. For more insights, visit us at hl.com. If you enjoyed the episode, let us know by leaving the show a rating and review on your podcast platform of choice.