Co-investing is for the 1% - Co-investments are not created equal
Private equity co-investments inherently have different levels of risk. Following up on the last posts about the motivations and prerequisites for co-investments, this post looks at how LPs at the co-investment level can think methodically about risk.
To do so, LPs can use a Co-investment risk matrix, which plots co-investments according to
Knowledge of the GP
Doing this enables the investor ex-ante to consider the overall risk of the co-investment and ex-post to assess the outcomes in a structured fashion.
Co-investments are about good risk-adjusted returns
However, fancy modelling aside, risk can, just like return, be very difficult to quantify ex-ante, making it difficult to put into a risk-adjusted return context.
Nonetheless, for co-investments it is nonetheless possible and useful to think methodically about risk. Figure 1, the ‘Co-investment risk matrix’ is one that I have found practical.
Figure 1: The Co-investment risk matrix
Source: PE Compass, 2022
Note: For illustrative purposes only
The Co-investment risk matrix
In the matrix, co-investment opportunities are plotted according to how much ‘knowledge’ the LP has of the GP along the Y-axis and how ‘complex’ the co-investment is likely to be along the X-axis.
This gives a very tangible sense of how risky a co-investment may be, both on an absolute level as well as relative to other co-investments. And, in this context, about the overall risk of the co-investment and what would then be an appropriate expected return. I.e., in Figure 1, Co-investment B should, all else equal, have a higher expected return than Co-investment A.
The Y-axis – knowledge of the GP?
All else equal, the more an LP knows about a GP prior to making a co-investment with them, the less risk.
The LP may have tracked the GP for several fund cycles, conducted primary fund due diligence and made a commitment. This gives significant insight into how the GP operates and consequently helps mitigate risk compared with making a co-investment with a GP that that the LP knows less well.
In the latter case, the LP would very likely need to do due diligence on the co-investment and on the GP in parallel, while probably facing a deadline. Quite obviously increasing the overall risk.
Especially if co-investment complexity is also low, it is also reasonable to argue that there is lower ‘GP risk’ if co-investing with so-called ‘Blue-chip’ GPs. These GPs would most commonly be the largest and most sophisticated GPs, who run multiple strategies, for whom co-investments are very common, and where they often run co-investment syndicates. While it does not mean the investment necessarily is attractive, it does mitigate some risk.
Obviously, regardless of which GP, the more knowledge the LP has of the GP prior to making a co-investment, the better.
The X-axis – how complex is the co-investment?
A syndicated co-investment will, all else equal, have less risk than a co-investment where the LP takes underwriting risk alongside the GP.
While the terms will already be set making it a ‘take it or leave it’ for the LPs, a syndicated co-investment will often benefit from a well-organized process and data room. Compared with underwriting a co-investment this mitigates some risk, not least execution risk, and the LP will typically have to expend less effort and resources. Notably, the LP may nonetheless still be working on a tight timeline, necessitating adequate resources.
At the other end of the spectrum is a fully underwritten co-investment. Here the LP will almost certainly need to be able to move at speed to meet tight deadlines. This necessitates processes and governance that facilitates doing so. Critically, the LP in these cases also needs to be able to absorb any broken deal cost. While not a strict requirement the LP will in these cases benefit immensely from having an adequately resourced and incentivized team with some domain expertise.
Risk is distinct to the LP
LPs need to be very conscious as to what type of co-investment they can underwrite and how much risk the are comfortable with.
This is not just a question of how large the investment programme is but also, as mentioned in the prior post, the resources available to the individual LP. Accordingly, different LPs will in all probability plot the exact same co-investment differently in the risk matrix.
As an example, imagine two LPs with approximately the same resources looking at a syndicated co-investment. LP 1 has made several commitments to the GP and knows the GP very well, and accordingly plots the opportunity in the lower left corner of the Co-investment risk matrix. LP 2 is conversely not very familiar with the GP and will consequently plot the opportunity further up on the Y-axis towards the top left corner.
All else equal, LP 2 is in this example taking relatively more risk than LP 1 and needs to factor this into their return requirements.
Co-investment risk is not investment risk
In fact, while connected these two are quite distinct. Where co-investment risk can be assessed relatively easily, using the Co-investment risk matrix or something similar, assessing investment risk requires doing comprehensive due diligence.
As an example, take investments A and B in Figure 1 – where A is an Early-stage Venture Capital co-investment opportunity in carbon capture and storage and B is Large Buyout of a leading global manufacturer of critical safety components for commercial airlines. The LP knows the Venture GP very well but has limited prior knowledge of the Buyout GP.
At the co-investment level, as can be seen in Figure1, B is, all else equal, riskier than A. Conversely, at the investment level, A is, all else equal, far riskier than B.
How to potentially determine this risk, is the topic of the next post.
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