LONDON Tired of the hefty fees charged by private equity firms and wanting more say over what they buy, big investors like pension funds and insurers are taking matters into their own hands.
Some are buying stakes in companies directly or teaming up to invest alongside private equity firms rather than locking money away in those firms' funds.
That is posing a challenge to the $3 trillion private equity industry, where companies like KKR and Apax spearheaded the model of raising money from investors to put to work on their behalf in exchange for management and performance fees.
For the first time in their history, buyout firms are raising less money from investors, and there are signs that trend could continue.
According to industry tracker Preqin, 43 percent of investors in a survey this year said they planned to increase the money they put into co-investments, in which investors do deals alongside buyout firms but pay no fees.
The proportion of investors that currently co-invest had also risen to 36 percent by the first quarter of this year, up from 33 percent a year earlier, the surveys showed, indicating rising interest in investing outside traditional funds.
"Co-investment is an effective mechanism to get your fee down and it gives you more control over your exposure," said Simon Moss, Head of Europe at Hermes GPE, an investor with 20 percent of its 6 billion pounds ($9.1 billion) in assets in co-investments.
In a private and opaque market, estimating how much capital bypasses private equity funds is difficult, but there are signs more investors are publicizing an alternative approach.
British insurer Legal & General said on Monday it was taking a 46.5 percent stake in UK housebuilder CALA Group alongside Patron Capital, part of a plan to do more direct investments in education, housing, transport and energy.
It follows big investors like The Canada Pension Plan Investment Board (CPPIB), which last year bought a stake in motorcycle grand prix organizer Dorna, and the Ontario Teachers' Pension Plan Board in doing more deals outside of funds.
The $173 billion-strong CPPIB has now bypassed funds for more than $11 billion of private equity investments, according to its website, against $42 billion committed to funds since 2001. Past direct deals include stakes in jet engine component maker Avio and health and beauty group Alliance Boots.
In expanding co- and direct investing, pension funds and insurers are, in part, mimicking sovereign wealth funds which have long taken it on themselves to scour the world for assets.
The question of fees often looms largest in choosing how to put money to work. Backers of buyout funds typically face annual management fees of 2 percent and performance fees of 20 percent.
But the apparent cost-saving of avoiding fees can be misleading, as investors need in-house expertise and time on the road to examine possible deals. More concentrated exposure also means returns - or losses - are amplified.
Andre Bourbonnais, who leads private equity investments at CPPIB, told delegates at a recent conference in Berlin his fund has a team of 45 people in Hong Kong, London and Toronto "dedicated exclusively to executing on direct transactions."
These staffing costs make going direct prohibitive for smaller investors, though by teaming up for direct stakes they can glean knowledge to help them decide on future deals.
"Sometimes private equity firms become so focused on securing an investment at the expense of thorough research ... With a co-investment model, there is greater scope to objectively evaluate an opportunity," Hermes GPE's Moss said.
Heavy writedowns of their private equity fund holdings during the financial crisis has added to investors' desire for more control over which companies they back.
But unlike the activist private equity manager, pension funds often prefer a hands off approach with the companies they own, and do not put their own staff on to boards.
This reluctance to commit extra resources to an investment means a lot will limit themselves to co-investing, where they can piggyback - but are also reliant - on the restructuring changes their buyout partners make to portfolio companies.
Where they do own stakes directly, pension funds often keep assets for longer than buyout houses, reducing the need for quick exits - a problem for private equity funds during the financial market crisis when deals dried up. Walgreen's purchase of a stake in KKR and CPPIB-owned Alliance Boots last year shows it can be done, however.
Desperate for cash as clients cut back, private equity firms have shown themselves willing to team up with investors outside of their funds, even offering prospective clients the chance.
Hermes' past deals include a stake in law firm Parabis alongside Duke Street, and a stake in Brit Insurance with London-based private equity giant CVC.
Some private equity executives say the rise of co-investment does not threaten their business model - rather, it aids it because investors are more likely to back their funds in future.
Private equity firms that successfully offer co-investments will be the "winners" of the future, Head of Infrastructure at AXA Private Equity Mathias Burghardt said.
"The ability to offer co-investments is very important," he told Reuters. "The investor wants to shape his own portfolio."
Other executives caution about the rush to team up outside the fund, and say a balance must be struck.
While investors want to learn about prospective deals as early as possible, buyout houses say bringing them in at initial stages is a non-starter because they do not want to reveal their hand until they are sure about price, financing and structure.
This leaves pension funds and insurers with a short window to decide whether or not to back a deal.
"We tell them you've got three weeks. In three weeks you either say yes or no. Sometimes that's too tight for them," one industry executive said at a conference in London last week.