The significance of shadow capital in private equity investments
Limited partners (LPs) are turning to shadow capital as they look for newer and more innovative ways of deploying fundsShadow capital allows LPs to access the private equity asset class without having to depend on general partners (GPs)
Mumbai: As private equity (PE) deployment increases and touches record numbers in India and across the world, limited partners (LPs) are turning to shadow capital as they look for newer and more innovative ways of deploying funds. Mint gives you the low-down.
What is shadow capital?
When LPs—institutional investors such as pension funds and sovereign wealth funds that invest in PE funds—invest in private equity opportunities either entirely by themselves or selectively partner with the general partner (GP, the PE fund manager), it is known as shadow capital. This allows LPs to access the private equity asset class without having to depend on GPs.
LPs would either not have to pay the associated management fee that fund managers charge or would only have to pay a reduced fee. This boosts the returns of LPs while reducing costs and gives them enhanced control over where their money gets invested.
How is it different from regular private equity investing?
Shadow capital investing comes in many shapes and sizes. LPs either indulge in direct investments on their own or co-invest alongside the PE fund manager or GP. Sometimes, LPs also set up separate accounts of large capital pools that the GP can manage on their behalf across various strategies.
In co-investing and separate accounts, the private equity firm leads the deal sourcing and due diligence activities and management of the portfolio of investments, while direct investments require an LP to develop these capabilities in-house.
What are the positives for LPs and GPs?
The GP can write big cheques, while the LP can learn deal sourcing from the GP. This gives the LP direct access to the PE asset class and reduces its management fee.
What are the negatives?
When LPs go solo investing, it could be a threat to GPs that end up competing with pension and sovereign funds—institutions that have large sums of capital to deploy. While LPs will not have to pay a high management fee when investing directly on their own, they have to take up a tough and newer role of doing everything that PE funds would generally do for them, such as sourcing of deals, due diligence on the asset, managing the asset post investment and seeking potential exit paths.
Will shadow capital continue to grow?
According to a Financial Times report, while shadow capital accounted for about 11% of total deployments in 2011, this rose to 25% in 2015 and continues to rise.
This is further evidenced by the large stand-alone deployments seen by pension funds and sovereign funds, among others, in companies directly, instead of via PE funds.
The challenge for GPs, which will probably continue to grow, is to fend off pressure to reduce prices for their services and find new ways to partner with LPs, which benefit both parties.
Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!