The evolution of PE co-investment

September 2019  |  FEATURE  |  PRIVATE EQUITY

Financier Worldwide Magazine

September 2019 Issue

As a tool to reduce fees and generate additional value through private equity (PE), co-investment has become a compelling option for limited partners (LPs) in recent years.

In turn, general partners (GPs) have used co-investment opportunities to enhance their own deal-making capabilities, cultivate relationships with important investors and increase the number of transactions in which they can participate.

A sizeable and diverse market, co-investment, notes Cambridge Associates’ 2018 report ‘Ready, Steady, Co-invest’, accounts for nearly one-third of all PE activity. The escalation is attributable to a range of factors, but in the main because it enables investors to participate in potentially highly profitable investments, without having to pay the usual fees charged by a PE fund.

“The primary goal of any successful private investment programme is to serve as a meaningful return driver to the total portfolio, and the objective for co-investing is no different,” states the report. “Co-investing offers potential return enhancement through fee reduction, J-curve mitigation and the opportunity to tactically increase exposure to high-quality investments.

“Investors should not underestimate the fee-reduction benefits, as the average difference between gross and net returns for a US private equity fund is 725 basis points (bps),” the report continues. “Consequently, even a modest allocation to co-investing can improve the return profile of a private investment programme, as most co-investment opportunities are offered to existing LPs with no (or reduced) management fee or carried interest.”

In 2017, highlights the report, there was approximately $60bn of global PE co-investment deal flow, with PE firms calling around $266bn in capital from LPs, suggesting that co-investment activity composed approximately 20 percent of overall market activity. In comparison, McKinsey’s ‘Global Private Markets Review 2018: the rise and rise of private markets’ analysis, puts the value of co-investment deals in 2017 at $104bn.

“Co-investing has been available since the first PE fund was formed and raised, but not always in the form it takes today,” says Andrea Auerbach, head of global private investments research at Cambridge Associates. “It was less prevalent even a decade ago, when managers preferred to invest in each other’s deals – often referred to as consortium investing or colloquially as a ‘club deal’ – and LPs became frustrated paying fees and carry to multiple managers for the same investment.

Indeed, according to Cambridge Associates LLC Private Investments Database, while the median net internal rate of return of global PE funds declined from 20.2 percent in 1993 to 10.7 percent in 2015, the traditional fund fee structure remained essentially unchanged. “Investors are collectively paying the same price for half the return, individual fund performance notwithstanding. Enter co-investing,” adds Ms Auerbach.

PE activities

As well as enabling investors to significantly decrease the fee load for their PE fund investments, co-investment also allows practitioners to explore all manner of investment vehicles – activity driven by the current strength of the PE market, worth approximately $2.8 trillion globally according to a 2018 Preqin report.

According to MJ Hudson’s 2017 guidance ‘Private equity co-investments: the manual’ co-investments tend to arise in the following scenarios: (i) a portfolio investment exceeds available sponsor fund commitments, typically during the fundraising period or where the sponsor fund is reaching the end of its investment period; (ii) the investment would breach restrictions contained in the sponsor fund documents relating to diversification, or limits on sector, geography or industry; or (iii) the investment is too large for the sponsor fund and would create risks which outweigh the benefits to the sponsor fund.

“Co-investment activity has increased in recent years due to an overall robust PE market, whereby smaller funds are partnering with deeper pockets to access larger deals,” says Bob Snape, president of BDO Capital Advisors. “There has also been growth in the number of fundless investment funds – sponsors that have not raised a fund but instead raise capital on an investment-by-investment basis to identify and structure attractive investments, with additional capital helping to consummate the deal.”

“In addition, there has been a rise in sponsors setting up dedicated co-investment vehicles, with co-investors committing a specified amount in the vehicle upfront, before any deal opportunities are sourced,” he continues. “These vehicles tend to be in a position to react faster as investment opportunities arise, as it eliminates the need to negotiate terms on a deal-by-deal basis. It also makes them more credible with sellers and investment banks marketing the deal.”

Mr Snape’s contention is backed by a 2017 survey by the Asante Group of 112 LPs, 54 percent of whom indicated a willingness to make a co-investment alongside a deal-by-deal manager – an investor that pursues acquisition targets without a fund to finance them.

Advantages

The advantages that co-investment offers LPs are numerous, but can be generally boiled down to reduced fees and the scope it gives them to control capital deployment.

According to the Cambridge Associates report, the key benefits of co-investment for investors are the potential for high returns, lower fees relative to fund investments, J-curve mitigation, more flexibility and control in constructing a portfolio, and more effective risk management.

“Managers offer additional access to their investments outside of the fund structure and fund fee structure, often on a no fee, no carry basis,” suggests Ms Auerbach. “By pursuing those co-investing opportunities, investors can materially reduce their cost of access to the asset class, bringing it more in line with current median private investment returns.”

As far as fundless investment funds are concerned, investors are charged a lower management fee and a range of carried interest based on the performance of the investment. “This process is attractive to investors because they access a larger number of transaction opportunities at lower fees than through a traditional fund investment, plus it aligns incentives to manage the investment effectively,” explains Mr Snape. “A co-investment vehicle gives the sponsor another pool of committed capital from which it can draw to complete a transaction, which means that the sponsor’s primary fund does not need to fund in excess of its target equity allocation at closing and then rely on a successful syndication to achieve its target allocation.

“While this structure gives co-investors access to a stream of co-investment opportunities with preferential economics, the drawback for co-investors is that they lose the ability to choose the co-investment opportunities in which they would like to participate,” he continues. “Instead, they automatically participate in all co-investment opportunities the sponsor allocates to the dedicated co-investment vehicle.”

For Eamon Devlin, a partner at MJ Hudson, co-investment is also a useful tool for GPs to attract new and bigger institutional investors into their products. “Co-investment is forcing many sponsors to be pulled off their stated fund investment strategy, whereby they end up hunting for, and closing, investments at a much bigger size than the investment strategy recorded in the fund documents,” he contends. “This can and does create misalignment with investors that participate in co-investment and those that do not.”

Challenges

Yet, for all the advantages that co-investment presents, there are downsides, with a number of key challenges in the mix. “Although co-investment will definitely lower the overall cost of access to the asset class, it has some obvious challenges, pitfalls and risks – such as adverse selection – and is not a guarantee for higher returns,” points out Ms Auerbach.

“Investors would benefit from a proactive and selective approach rather than an automatic one,” she suggests. “Co-investing is essentially one of three control levers available in broad-based institutional private investing: fund commitments, co-investments and secondary transactions.” In addition to adverse selection, additional challenges posed by co-investment include the need for a significant amount of resources and expertise to oversee and evaluate an investment, tight response times and the time it takes to get to critical mass.

Also a concern is the issue of ‘hidden’ fees. “There may be no ‘management’ fees being charged for co-investments but a plethora of other fees are being charged, such as financing, closing, exit and board fees,” asserts Mr Devlin. “The industry could do better at being more transparent.”

Downturn

While the current co-investment landscape is a rosy one, some commentators question the prospects for investors in the event of a downturn. Pointedly, what would be the capacity of co-investors to meet the financing needs of portfolio companies in distress should the co-investment boom turn to bust?

“Concerns of a recession or downturn are prevalent but not to the point of causing a material change in investment activity,” says Mr Snape. “Co-investment strategies and vehicles allow sponsors to continue to make bets but at a reduced capital level as they share the risk and return with syndicate partners. If a co-investment portfolio company is in distress, there are still funds available to meet financing needs, but there are also more constituents and seats at the table that have the potential for differing opinions on how to right the situation.”

Tailwinds or headwinds

Whether it is headwinds or tailwinds for the economic landscape ahead, for the moment, the co-investment tool appears to be winning the PE market popularity contest. Indeed, Private Equity International’s 2019 survey ‘Perspectives: What really matters to private equity LPs’ found that two-thirds of LPs plan to invest in co-investment opportunities over the next 12 months.

“Co-investing is not going away anytime soon,” asserts Ms Auerbach. “With co-investments, you can actually time the market by deploying capital at a specific moment – in a private investment context. Compared to making a fund commitment, that is quite an opportunity, and one well worth considering.”

Also forecasting continuing evolution in this space is Mr Snape. “Co-investment activity will continue to grow and become even more popular than it is today,” he believes. “There are significant tailwinds to keep the momentum going.” Equally forthright is Mr Devlin, though with caveats. “Co-investment will continue to grow as a trend as long as management fee levels for mega PE funds remain high,” he predicts. “Management fees for PE will decrease one day – and when they do, co-investment levels will quickly diminish.”

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Fraser Tennant