Rise of shadow capital challenges administrators

The dramatic shift in the private equity industry towards ‘shadow capital’ raises fresh challenges for administrators because it requires a level of flexibility that some may find difficult to deliver.

Many co-investments, direct investments and managed accounts can be considered shadow capital. Instead of allocating to a blind pool, shadow capital investors negotiate bespoke terms and lower fees – and they can have a say in what investments a fund makes.

These kinds of investments were previously the domain of a handful of deep-pocketed limited partners (LPs), but they are now much more widespread – placing greater demands on fund administrators.

For example, each shadow capital investor will require different terms and a standard limited partnership agreement isn’t sufficient. This requires sophistication, accuracy and attention to detail from the administrator.

Rapid rise of shadow capital

In 2015, shadow capital totalled an estimated US$161bn or 26% of all private equity fund raising, according to Triago. By comparison, in 2010 it totalled just US$24bn, equating to 11% of fund raising.

Shadow capital is becoming more popular as large investors seek more control of their investments and find that they earn better returns from having it. The largest investors, such as pension funds, can put more money to work in private equity without diluting returns by spreading their investments across a large number of managers. They can also negotiate lower fees than the standard 2% for management and 20% for performance.

Driving higher returns for LPs

There’s growing evidence that shadow investing yields higher returns. As recently as 2012, only 13% of the LPs interviewed for a Preqin survey believed that returns from co-investment were significantly better than those of a typical fund. But in Preqin’s latest round of interviews in March 2014, 52% of LPs reported that their co-investment returns were far higher than the returns their funds generated – and none said they were lower. With that proven track record, 77% of the LPs said they were now co-investing and more than half said they planned to do more of it in the future.

Vital role for administrators

Administrators play a vital part in making this more bespoke form of investing work. They need flexible systems that can handle the different investment terms, as well as additional share classes and structures. They must have people with sufficient experience to set up customised solutions. And they often must have a global reach that can bring together investors, managers and investments based in different parts of the world.

Taking the shadow capital trend to its logical conclusion, the biggest pension funds and sovereign wealth funds are likely to build more in-house private equity teams that select and invest in deals. But to account for their investments they are likely to require external administrators that can provide both professionalism and transparency.

10th March 2016

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Niall Fagan

Niall Fagan

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