Damian Cilmi: Welcome listeners to another episode of the Premium Investment Leaders Podcast. I'm your host, Damian Cilmi, Head of Investment Managers and Governance at Praemium, one of Australia's leading specialist investment platforms. Today, we're heading into the world of private equity. With this asset class, one of the fastest growing areas of interest for all investors around the globe.

Very fortunate to be joined by a leading expert in this field, with José Luis González Pastor joining us from London via Madrid, to walk us through some of the key issues in this space and work through some of the key strategies used by private equity investors, but sometimes little known, and that is, co-investments.

And about our guest, Jose Luis Gonzalez Pastor is the Managing Director of Neuberger Berman in the Private Equity Team and a senior member of the firm's Private Investment Portfolio Group where he leads fund investments and direct co investments. He has over 18 years industry experience through private equity and investment banking and has now been with Neuberger Berman for 11 years.

And about Neuberger Berman, founded in New York in 1939, and today located in 26 countries around the world, employing over 2, 800 staff, managing over U. S. 450 billion. The Private Markets Group was founded over 35 years ago, managed over 120 USD in assets for a range of institutions and private wealth investors around the globe.

José Luis, welcome to the show.

José Luis González Pastor: Thank you very much for having me.

DC: And welcome to Melbourne as well. I hope you had a nice journey here.

JLGP: Yes, so far so good. That good, good.

DC: And whilst we'll, we'll delve into the detail on co investing as a, as a strategy is the real focus of today, but it's worth covering off on some quick background around the private equity market.

So let, let's start, let's talk about your private equity. It continues to be one of the fastest growing areas for investment. So, what are the major drivers for this increase?

JLGP: Well, first and foremost, private equity continues delivering, continues delivering good returns over cycles, over periods of time.

And when you have a year like 2022 where capital markets shown a lot of volatility and again, you look at private equity performance in general. It was a very muted year. That's the other virtue. It has low volatility. So, for investors, having an asset class that delivers returns constantly with low volatility, it's very appreciated.

Another thing that is happening these days is that there is more and more different type of investors, including high net worth individuals and retail investors. So now they have an alternative that before they were not having access to. So that's also important. And we also need to remember that from a diversification perspective, public markets over time have fewer listed companies than before.

Companies take longer to get into market. Whereas in private markets, you can access a broader. Number of companies on a study, so it's also very compelling to have. Another layer of diversification in your allocation in your portfolios. Sure. And I think there's an interesting stat around the number of US- listed companies has been really reducing over time.

DC: Yes, First, because a lot of companies have been taken private. Yes. Interesting enough by private equity.

JLGP: And the other thing is that many companies, they have chosen to stay private for longer. There is more and more private capital that can fund the next growth stages of these companies at different levels.

And some of them, honestly, they prefer not to have all the scrutiny and short-term views, I would say, of public markets. Yes. So, they prefer to try to lure a private market and long-term investors, which you can also find on the private sector or on the private pay. equity side like long term funds to stay private for longer.

1. So that's kind of, let's say that's the supply equation there. Let's talk about the demand equation as well, about allocations within portfolios. So, what are you seeing in terms of like the weight of private equity in portfolios around the world and direction of where that's heading?

JLGP: Yes. Well, it depends on the type of investors.

I would say traditional private equity investors, which have been public pension funds and private pension funds. They keep allocating. Probably their stated target is anywhere between 5 to 10 percent. Usually, they are a little bit underweight because it just takes them time to ramp up their programs.

But that's what they are targeting and depends on, depends on geographies. Probably insurance companies are the ones that have the lowest one. And probably is driven a lot because of regulatory constraints, especially Europe. But one area where the I would say they are leading in terms of allocations are precisely endowments.

Yes. You, you, we know the big universities in the U. S. They're close to 25%.

DC: Yale. Harvard as well. Close to 25%.

JLGP: And family offices are also in the range of 15 to 25%. Now, if we go back to the mass affluent market that they are starting from zero. We are having plenty of conversations with financial advisors these days. They're trying to first bring them to 5% by the long term.  From zero. And the long-term goal is to bring them to 15%. And part of the argument, which. I also buy very much is look, we're talking about a pocket of capital, which is called equities. You can access it via public equities or private equity.

DC: Yes, that's a really good run there. And I think, you know, the imperative, like a lot of people at zero are ramping up, and that's where I suppose the demand is there. And let's go through the major, well I suppose there's three major types of transactions that you might get yourself involved in.

JLGP: So, we've got primary, secondary, and co invest. So, for the listeners benefit, just kind of go through how you may benefit. Purchase a company. So primaries in our world means to allocate capital to a third party private equity fund. So, we make a commitment and then they will be drawing capital over time to buy companies.

So, the actual manager of the companies, the ones that they are driving, they are in the driving seat. Basically, they are there. So, we are allocating capital to different funds and we're looking for the best managers, obviously. Over time and thinking that they can execute on that strategy.

Secondaries means well, there are two types of secondaries. There are the LP led secondaries and there are the GP led secondaries. Let me delve into both for a second. Secondaries as the name kind of suggests, it's a second-hand investment. Yes, for a better or simpler explanation. So, if on primaries you have made the first original commitment to a fund on secondaries, you are buying from that existing investor and replacing him in the fund structure.

That's the LP the limited partner is selling the interest. The GP let, it's also another way of second hand. They have owned the asset in a fund structure, and they want to move it to another fund structure. So, they need to replace everything, basically. They need a new fund with new investors.

And that's a GP let. Because it's the GP, the general partner, who is driving that.  Sure. And then we've got co investors, the last one as well. Correct. We'll talk a lot about that, but like, what's the quick definition of a co invest? Co investments means to invest in a company alongside the general partner, the one that we made the primary commitment, we mentioned before, but you invest as a minority investor.

With minority protections, you're not managing the company either, but you're facilitating that the general partner is acquiring that company. Sure. And so, in that there, I think it's probably co invest is maybe an area that people may not be familiar in. Probably on the primaries is when people think about private equity, that that might be the most common one.

DC: Neuberger probably early pioneers in the co-invest space as well and probably still one of the most active in this space You know, how did this transaction type come about like what was the origins out of all of this?

JLGP: And if I can do a little bit of history here, early in the days there was co-investments that were just not in the mainstream. Think about before the great financial crisis. So, when a general partner needed more capital to complete a transaction, usually they invited one of their competitors to join forces. Now during the great financial crisis, that didn't go very well because there were basically two chefs in the kitchen and they have different ways of, or different views of how to So, since right after the great financial crisis we saw a significant increase in co invest because general partners realized that investors, limited partners like ourselves, were much more friendly passengers in their investments than could be a competitor.

So that's, that's the general framework. So, usually the investments that we, we get involved with are It can come out of two ways. The first one, which is the most obvious one, they want to acquire a company and then They don't have enough capital, and they call their largest limited partners. And we're one of them in many, many funds.

The other one is that we proactively approach them with liquidity solutions for their portfolios in order for them to rebalance or manage the aging of the different companies and at the same time providing some liquidity to their investors. Sure. a pull or a push, I would say in that sense. So those, those are the two ways where we see co-investment opportunities.

And I would say on the, on the, on the one that we are more proactive, I would say whether we are more innovative and leading into the market. I think the vast majority of the market is more aware of the traditional, okay, this GP, they need some money for completing the trans, this transaction, and then they ask for coinvest capital.

DC: Okay. And then again, we've got three layers of primary, secondaries and Co Invest. But then I think even delving down into Co Invest, you've got another set of layers or types of transactions. So, you talked on some of them like traditional being shortfall, but let's go through like some of the other types of transactions that could go in To Invest.

JLGP: Well, we have the traditional syndicated as you mentioned before, but that's a very simple process. Articulated very little capital available there where we can be really helpful. It's when we participate as a co-underwriter. So, they're in a in a process. They need to put the play and they need to place a bit.

with some terms. And in the meantime, they are organizing the third-party due diligence providers to provide them with all the reports. So, we work alongside them. We receive the same reports at the same time. We attend the management presentations. We give them our views of the business and the pricing and the dynamics for them.

But in the end, they decide how. What is the price to bid? But the important feature here, as a co on the right, is that they need our money for the final bid. They need our signature, if you will, and our capital. Usually, to participate in this part of the market, you need probably to be around 100 million, able to speak for around 100 million dollars.

So, the number of co investors in that space is relatively limited, as you can imagine.  And we can speak up to 500 million so we can fledge and flex our, our commitment. And that's very helpful for them because without our capital they cannot even place the bid. Whereas on traditional syndication, look, they can stretch a little bit, they're fine, so.

It's not a big deal for them, but in this situation, either they have this additional Coinbase capital, or they cannot put a bid. Yes. And I suppose, what's the direction or the number of transactions you're doing across those three? Is there any particular change in focus, let's say? So, over time, we are less and less dependent or reliant on the traditional syndication.

Yes. And I would say over the last four or five years, Co on the right represents around 50 percent of the capital that we invest. Syndication or traditional syndication could be around 15 to 20%. And the new area, where we're growing more and more, that is the innovative part that I was mentioning before, is what we call midlife.

Yes. Which is the third category that we wanted to share today with you. Midlife, for lack of a better name, we chose that name because the company has already been owned by the private equity fund for a while, and there is an event that requires more capital. The paramount example is when their immediate competitor comes up for sale.

The, the private equity manager probably has not reserved enough capital for making that acquisition, so that's when they ring a certain dedicated co investors that they have the capabilities to put capital Not at the beginning, not at the original valuation, but at a different valuation in order to make the acquisition, strike synergies, and exit down the road.

Yes, and so they're bringing in these extra investors, it's maybe not the most ideal thing that they wanted at the start, but there's still benefits for them though. Absolutely, because it's extremely accretive for them. And also, will facilitate and accelerate. The path to an exit. Yes. If you are number three and you're able to buy number two, suddenly you become number two at exit.

Yes. And that will command a premium when you're selling, rather than if you're still in number three at exit. You're going to Yeah, yeah. Correct. Keep the price of number three. And I think we, we, we spoke about this a while ago about, I suppose continuation funds as well, where it can strike a valuation as well.

Yep. At that co-invest and that's. Probably another feature as well. That's another feature of myth life. So, the paramount example I just mentioned, which it's a capital injection that connecting with what we were saying before, sometimes we approach the companies recently. We approach a U. S. Manager. They have invested in a very good company that has been growing for a long period of time, and they invested through two funds, a 2016 vintage fund and a 2019 fund, right?

And so. We are in 2024, right? It's time for that 2016 fund to divest. So, approach them and say, look, we have a solution for your older fund. Would you like us? You know, to transact, we give you a valuation. Obviously, from our perspective, it's not going to be a full control valuation price. So, it removes tension from the negotiation because we're a minority.

And I thought it was a good idea. They work with us for a while and now we're co investors alongside the newer fund and we're aligned for the next three to five years. And they, on their side, they have removed the pressure of having an old fund and still invested in the same company for eight years.

There's a lot of innovation in this space as well, you know, in transaction types. It's quite fascinating. And so, we've talked about that, you know, from a GP perspective, but what about the LP, the investor? Like, well, what are some of the benefits that investors get in participating in these transactions?

Let alone access to the deal. So, when you invest in primaries, as we were mentioning before, what you're doing is a commitment into a blind pool off of capital sheet of paper. Exactly. What? You trust them that they're going to be buying good companies.  But you have two problems. Once you don't know if they're going to be good companies, and you don't have a say about that on second.

You don't know when they are going to do so on co-investment. It's very capital efficient, and you also have more control around it. A lot of thought as well. Exactly. You see what is the company, you can see what the company has been done, doing, and you can make your own mind around it, right? Once you make the commitment on primary basis, you cannot say, hey, I really don't like that company that you bought, right?

It is what it is. Here you can choose. And then at the same time, you, you can analyse many more opportunities globally at the same time. So, you can put more capital to work fast. Otherwise, you would not be able to do that. Now, as I'm inferring already, it's very human resources intensive, right? If you really want to analyse a lot of opportunities and make  Yeah.

Make a decision. Actually, you really have the capabilities, but also the team. For instance, at Neuberger Berman, we receive 11 co-investment opportunities per week, so our investment committee needs to meet three times just to deal with all the,  all the deal teams like, like myself that I lead some from Europe to give answers and feedback. And we're and we can be very selective as well, right? The more the funnel, the bigger it is the better for selectivity. So, we choose around 10 percent of what we see.

DC: And what about on the fee structure as well too?

JLGP: That's another, that's another interesting point. Look, we are, we have other pockets of capital that are making those primary commitments. So, we're paying full fees and carrying.

DC: And what's the, for the listeners benefit, what's the rough numbers? So rough numbers, management fee, it's around one and a half to two percent per annum.

JLGP:  Yes on a committed basis. That's usually during the investment period, which is usually half of the term of the fund. And then the carried interest is around 20%. That's actually a pretty fixed number.

DC: So, people may have heard about two and 20 type of.

JLGP: The two and 20, that's, that's the two of the management fees and the 20 of the carried interest and the carried interest is 20 percent of the capital gain.  

DC: Sure. That, that they get, assuming that you get it over an 8%.

Pref return which usually they get there. Yes, yes. And under these transactions, the 220 does not necessarily occur here. Not necessarily. For co investors. Yeah.  Usually what happens, if you are already an investor in the fund, or in some of other funds of the GP, they waive the management fee and carry the interest for you.

DC: That's crazy. So, in that sense, it's free?

JLGP: Now if you are not if you don't have any primary commitment to that GP, you very well probably be paying probably a 1 10. So, 1 percent and 10 10 percent carried interest. But It's a little bit logic. You don't have any other business with that general partner. So, and to be honest, there are some investors that they just do that. They say, look, we don't have the capital to make fund commitments, but still, it's a better proposition paying 110 than 220. Plus, they have the ability to choose what investments do they invest in. Yes, no, that's a, it's a very interesting element out of that there.

DC: And so, let's bring this all together and kind of bring it to life via a deal example. So, what's been one of your favourite deals that you've done in as a co investor?

JLGP:  Yes, look there is now the largest European non-food discount retailer called Action. This is originally a Dutch company.  It was acquired originally by 3i PLC, which is publicly listed trust in the UK.  And they invested originally in 2011, and they grew it.  You cannot even imagine how much they grew it. But from being just one country to many countries, extended to the right and to the left of Europe. So, they're in Germany and Poland, they're in the Benelux, they're in France. And now they are extending into Spain, Italy, Slovenia, Slovakia.

Anyway, they invested it from a fund. And by 2019, it was obvious that they would need to liquidate that fund. They had already exhausted all the extensions. So, they had to move that investment somewhere else. They wanted to reinvest. So, they invited another G. P. E. In this case, it was Hellman and Friedman to crystallize what was going to be the valuation and co-investors, because it was a very big investment on their side. And we invested very heavily, a couple of hundreds of millions into this company.

Obviously, we knew it very well as a fund investor into that fund. Okay. Right?

DC: So, yes, okay, you were in a primary.

JLGP: We were a primary investor, so we knew around it. That's why we were investor. Yes. That's how, that's why we were invited to be a co investor. Nice. And, and we invested very happily because we saw the trajectory and, look, they just started into Spain. In France, they have. 650 plus stores in Spain. They have to and the size of the two countries for everyone. Listen, if they're very similar. So, there's no Italy the same. So, there's no reason why this should keep increasing. They have never they have more than 2500 stores. They have never had to shut down a store because it's not working.

That's a proof of concept. The average basket is less than six euros. You don't find anything that is being sold there cheaper at Amazon. Okay. Which is fantastic. h. And then on top of that, they have It's, it's a rare story to, to see you know let's say a bricks and mortar store fight back.

DC: Exactly. Yes.

JLGP:  They're fighting back very well. Yes. And on top of that, they have borrowed also some concepts of I would say campaigns. So, they have the Halloween campaign, the Christmas campaign, the summer campaigns. So, they have specific articles that are very useful for those moments. And then the Zara women will know more about this. Every two weeks, 40 percent of the assortment is changed. So you really want to go back and say, Hey, what's new here? Right? So, they keep trafficking to the source. Anyway, we're extremely happy with how that is going. If you visit the website of F3IPLC, this is public information, but the company has more than doubled in value since we invested, or joined the consortium. And we're happy.  We're going to stay there for a while, probably. As the company keeps growing 30 percent year on year.

DC: And also, part of, some of your co investment, did that lead to the expansion now into like Mediterranean countries? Was that part of the plan?

JLGP: It was part of the plan, yes, to support them. And you know, while keeping very, or relatively low leverage. Also to redo in the capital structure, because the new investors, old investors, old fund, new investors, etc. It's great to get so close to, to a company, you know, growing there like that and being an investor along the way, so well done.

DC: And so, we'll just start to finish off.  We've spoken a lot about a co-investment thing that, that was wonderful, but we'll get into some other topical issues around private equity whilst you're here.  So, what are some of the common discussions or some of the common talking points that investors are asking you about what's going on in private equity at the moment?

JLGP: Yes, so the two comes to my mind valuations, where valuations are they coming down, up, right, left? The short answer is for good assets, valuations are still, I would say, full. Yes. But these are assets that they are growing double digits top line and with very little volatility. So, valuations are not changing dramatically.

However, they're starting to go down slowly, more in geographies like Europe than in the U. S. In the U. S., look, it's the largest market by private equity. There's plenty of capital out there chasing very good assets. So, the slowdown or sorry, the decrease in valuations is not really meaningful. But for good assets, the evaluations are relatively fullsome.

So, that is one topic that we get a lot of questions and that's the current status. And the other one is about, hey distributions from general partners, from funds. They have a slowdown because the number of exits has been dramatically reduced over the last year. And we're talking about liquidity.

And here the message that I want to send is that general partners are listening. They are looking for ways to provide liquidity and distributions to their limited partners. But we also need to understand them that the IPO market is shut. And they don't want to sell their very good assets at valuations that they don't think are the appropriate ones, right?

So, they may wait one more year, grow the EBITDA a little bit more, and then sell to a more reasonable valuation. And this is what we are starting to see now. Or, and that's why we are very active these days, we are structuring with them deals where they sell a little bit of their company, call it 5, 10, 15 percent.

They keep full control of it. They keep the company for longer, but they are able to turn back to their LPs and say, look, this is a distribution. You can take some It's original capital. Exactly. Chips off the table. Yes. And probably cost back of the original investment and a way of increasing distributions.

So, I would expect 2024. To have a greater number of distributions that what hasn't been 2023 on the back of, look, one more year of company's growth that, you know, may help on breaching the gap between valuations, buyer and seller, but also groups like ourselves that we're helping them facilitate in other ways to access liquidity.

DC: Yeah, I imagine you doing that through co-invest.

JLGP: Correct. Through co-invest. Back to the top. But also, on the GP leds that were mentioned before. That's another way of. for them to seek liquidity.

DC:  Yes, that's, that's interesting. And probably on valuation, you made me think about it. I suppose there have been a lot of questions around valuation methodology as well, too.

So has there been a lot of introspection and review on how, let's talk about yourself, for example. You can't talk about everyone in market, about what you're doing around your own valuation methodologies.

JLGP: Yes, look, the first thing that we, we do before investing in any manager, in any strategy, primaries, co investments, and secondaries, we do our due diligence, our operational due diligence on their valuation policy. And we try to understand how they value, how frequently, how robust are their processes. Once that has been validated and that they follow normal standard evaluation methodologies, we generally take their value or their valuations on a quarterly basis, almost like a face value.

DC: As long as they're within the boundaries, right?

JLGP: We have a range for it, all of the companies. If it's within that range, look, they can apply the multiples of that quarter, a selected multiples because they're more focused, or different ones. But as long as they're within those boundaries. We take that now for more dynamic funds that they have. I would say more frequent valuations on our side, for instance, are semi liquid funds that we need to publish valuations every month and for our listeners, usually private equity, they report on quarterly basis. So, there is obviously there is a gap. Then we have developed internal methodologies, basically regression models about So, how should we think about it? The main predictor is going to be public markets, so there is an adjustment. And doing back testing on, on our model, we have been able to predict with 95 percent accuracy, so only 5 percent plus or minus for those valuations.

But generally speaking, low valuations are relatively fair, but in the end, they need to sell. Now this is on the private equity market. I want to just make a remark. Venture capital where you don't have revenues. Sorry, when in some companies you don't have revenues and, in most companies, you don't have profits or if you don't, then valuations are a little bit wild. Yeah. Let's put it that way.

DC: A larger range.

JLGP: Very large range.  And it's very difficult to say whether it's a reasonable valuation or not. Because in the end, what happens is that you're going to need to wait until the next valuation round to see whether investors, they buy that. If that is the metric.

DC: And that’s your only marker, I suppose, or if you go to IPO. Yes, very interesting. That was an amazing trip around the world with one of the world's leading experts on private equity, José Luis González Pastor. Thank you very much for joining us.

JLGP: Thank you very much for having me here.

DC: Thank you.

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