The Growth of Shadow Capital in the PE industry

General overview

Starting from last year, capital allocation schemes that are hybrids of direct investment and limited partnership, namely “Shadow Capital”, have become increasingly appealing among participants of the Private Equity industry. This way of investing allows the Limited Partners to employ their resources benefiting from the expertise and experience of PE funds and to gain a direct foothold in the private firms’ capital. Most notably, Shadow Capital accounted for 25.6% of total capital committed in PE investments in 2015, surging from the 17.5% average it accounted for in the period 2009-2014 (see table below).


Classical scheme: General and Limited Partners

Investors in Private Equity typically belong to one of the following categories: Limited Partners (LPs) and General Partners (GPs). GPs, also known as Managing Partners, exercise managing ownership into the target company through the Private Equity funds they create. They take management roles in the firms the funds invest in and are subject to unlimited liability, thus taking the additional risk of having their personal assets seized in a bankruptcy filing. General Partners are, usually, firms that specialize and gain the necessary resource to have Private Equity as their core business.On the other hand, LPs commit comparatively less capital in the PE funds they include in their portfolios and take a passive role. The size of these commitments is part of their asset management strategy. They are subject to limited liability and pay fees to the General Partners for acting on their behalf, exercising the management rights they forego.

Alternative schemes: Shadow Capital

The traditional participation in a Private Equity investment as a Limited Partner has as an alternative one of the following investment schemes that fall under the umbrella of “Shadow Capital”.

Separate Accounts

This particular solution tailors the needs of sophisticated LPs willing to rationalize their exposure to Private Equity as an asset class while committing funds that exceed the typical needs of a single Private Equity fund. PE firms, rather than acting as a Manager Partner of the money invested in the portfolio, play more the role of an Asset Manager. This particular instrument allows LPs to monitor where and how the capital they commit is employed while paying lower fees. On the other hand, notwithstanding the lower margins and the constraints they are subject to, GPs can rely on a larger and steadier volume of assets under management for their operations. Limited Partners are showing increasing interest in this investment scheme. As shown by a survey conducted by Preqin, 18% of the respondent LPs actively invest in PE via separate accounts and another 25% of those surveyed expressed interest in moving in this direction.


This strategy appeals to LPs that want to exercise more discretion over the investment policy, without requiring the deal sourcing, due diligence and portfolio management skills of a PE firm. When accepting an offer to commit resources in a PE fundraising as an investor, LPs include in the agreement the right to decide in which deals they are willing to be a participant, hence exercising a much effective control on the employment of their funds. When it comes to selecting the investment target or actually managing assets after their acquisition, however, the co-investor’s role remains a passive one: the PE firm functions as a conventional General Partner exercising control over the target company.

This investment scheme has its strength in the possibility to align the interest of the LPs to the ones of the PE firm, yet diluting their margins and economics, which is why this is not an option PE firms are capable or willing to offer to any LP or any deal. According to Preqin’s analysis, 77% of Limited Partners surveyed are already co-investing.


This is a more active approach that enables important LPs (mainly institutional investors) to act as partners of PE firms by employing capital directly into the target firms. Co-sponsored investments can be mutually beneficial. Accordingly, PE firms can rely on the financial flexibility of institutional investors such as pension funds or sovereign wealth fund to take on investments of a much larger scale. On the other hand, LPs obtain a direct foothold in the companies they invest in, leveraging their partnership by learning from the seasoned guidance of PE firms and acquiring their own due diligence, negotiation and post- acquisition skills, with a view to value creation.

This strategy gives institutional investors the option to develop their own in-house private equity divisions. Nevertheless, this scheme is still limited to a small number of institutional investors due to the need of a wider asset under management and a specific know-how, essential to a more active and risky strategy of investment. As shown by Bain & Company, in the past five years, co-sponsorships accounted for less than 15% of deals exceeding the $1 billion dollar commitment, and about 60% of these deals involved only four institutional investors.

Solo direct investments

This approach does not involve the participation of a PE firm in the capital allocation, which is done by institutional investors on their own via direct acquisition of stakes in the equity of target firms. According to Bain & Company, there are no more than 100 institutional investors (less than 2% of the overall LP base) who can embark in direct investment programs, yet they control considerable resources.

Any LP contemplating a direct investment program must overcome hard challenges and face serious risks. First, she should be able to replicate the skills and the expertise of more seasoned PE professionals. Moreover, an LP operating as a direct investor foregoes all the benefits of diversification that come from putting her money in different PE funds, taking on more risk and accountability if an investment does not pay off.

For these reasons, LPs have been very cautious in their direct investments so far. They have completed small deals (rarely over $1 billion) targeting growth investments, minority stakes or private investments in public equities rather than buyouts. The firms they consider enjoy reliable cash flows, strong management and belong to the same geographical context. Finally, it must be noted how some institutional direct investors, particularly sovereign wealth funds in Asia and the Middle East, pursue deals in such areas as financial services, energy, telecom and infrastructure.

Strengths and disadvantages, a broader perspective

For LPs, investing outside the conventional PE fund structure has the advantage of boosting their returns and lowering their costs while obtaining a deeper awareness about where their money is put to work. LPs investing actively alongside GPs have opportunities to develop closer relationships with them and to gain a deeper understanding of their operating style and strengths, giving them the option to enter the industry in the future. For PE firms we have two opposite implications. Shadow capital investments complement their traditional relationships with LPs. In a tough and competitive fund-raising environment, the shadow capital option provides a more involved investment opportunity as a sweetener to encourage a LP to re-enlist in a new fund, sign on earlier or commit larger amounts. However, shadow capital and its progressive diffusion may also represent a threat for the PE industry. This trend may be considered, appropriately, one of the consequences of the low interest rate environment that financial intermediaries have to live in nowadays.

Private Equity as an asset class offered asset managers much higher returns (a 20% annualized IRR for instance) at the price of much higher risks stemming from the lower liquidity and efficiency of the PE market. This trade-off did not allow big institutional investors (such as sovereign wealth funds) to actively take large positions in this sector, due to their policies and risk- taking restrictions. Lower interest rates have had a double effect on the industry: on one hand, they made it simpler for firms to borrow money and rollover their debts, which –consequently- has avoided default filings for many of the financially distressed firms in PE portfolios. However, on the other hand, these market conditions have attracted the attention of other investors looking for better returns than the ones offered in other market segments.

The trend we have described thus far may increase competitive forces in the longer period, making it harder for traditional PE firms to sustain their historical margins and command their higher returns. This transition could either propel a disintermediation process – which could destabilize the whole industry and the traditional General-Limited Partner scheme – or either foreshadow an increase in competition for profitable deals that could lead to an overall evaporation of return rates.

We believe that the future evolution of interest rate levels will play a crucial role, attracting institutional investors back to their “traditional” asset classes or forcing them to explore even more the terra incognita of Shadow Capital, possibly expanding further the Private Equity industry.

Sources: Bain & Company Inc. – Global Private Equity Report, 2015; Triago – The Triago Quarterly, November 2015