Updated: Dec 5, 2022
As the private equity industry has grown and matured, especially over the last decade, more and more Limited Partners (LP) have begun looking at and doing co-investments (CI).
This not least as the QE fuelled bull-run of the last decade and half, which now looks set to end, has increasingly caused investors to look for yield further out the risk curve, and has made both direct investing and co-investing look easier and less risky than it is.
However, of the LPs that ask for co-investment opportunities probably no more than 10% of these will, when asked, follow through. The rationale for declining varies, but spans from, not being able to meet a strict timeline, not having the resources, capital, and people, to not actually having an allocation or a process.
In other words, it is more often a case of wishful thinking on behalf of the LP and / or securing a possible option than reality.
Further, of the 10% who follow through, probably no more than 10% of these investors should be doing co-investments anyway. This partly because their motivation may to begin with be ‘wrong’, and partly because they don’t, if they were brutally honest, actually have the prerequisite capabilities needed to make co-investments.
Consequently, co-investing is in reality for the 1%!
That said, when done with the ‘right’ motivation and ‘correctly’, CI can, be return enhancing, as can be seen in Figure 1 below, and add to portfolio diversification.
Figure 1: Private equity median net IRRs by vintage year: Co-investment vs. direct funds*
Source: Blackrock 2022
Note: Past performance is not indicative of future results
But for most LPs this is not always the case, and they would, especially from a risk-adjusted return perspective, be better off outsourcing it to a specialist provider – even if this comes at an additional fee.
If investors do want to do CI on their own it is essential that the investment team, as well as those tasked with oversight of the investment team and investments, take a systematic approach to CI, and fully understand their own motivations and capabilities.
In this regard, this post and the next ones look at
The motivations for co-investing
The prerequisites for co-investing
A framework for classifying co-investment opportunities
Co-investment considerations (and what GPs should consider when choosing LP co-investors)
Hopefully these posts will provide some thoughts and guidance for LPs already doing or wanting to do co-investments.
Motivations for co-investments can be more or less valid and differ from LP to LP
Here are, somewhat in the order of less valid to more valid, some of the more common motivations for doing co-investments and some thoughts for each.
1. Fee savings
Fee savings are not irrelevant as a motivation. But cannot, as often seems the case for many institutional investors, be a, or even the main motivation for making a co-investment.
Fee savings are a nice addition that hopefully helps provide increased net returns to the overall private markets portfolio.
2. Insight into a particular GP
This is a reasonably valid motivation, but not quite as straightforward as it may seem.
While investors undoubtedly gain much more insight into how a GP really works on an investment, which can be useful in determining whether to make a commitment to the GPs primary fund, than would be the case with a ‘standard’ primary fund due diligence, it also implicitly means taking on a much greater level of risk with that GP / single investment.
Critically, it also assumes that the investor has the prerequisite capabilities; team, knowledge, etc., to judge both the merits of the investment and the general investment capabilities of the GP. I.e., an investor would need to do a primary fund manager due diligence, while concurrently, maybe with a tight timeline, also doing investment due diligence.
3. Customization of exposure to particular sectors, regions, strategies
Especially, if done in alignment with portfolio construction considerations this is a reasonably valid motivation.
Some investors may have specific motivations or needs and / or insights that allow for taking more exposure than would be the case for other investors and can through co-investments customize / finetune their exposure and portfolio construction to their particular needs.
4. Faster deployment / j-curve mitigation
If done thoughtfully and within overall portfolio construction this is a valid motivation.
It is certainly possible to use co-investments selectively to speed up deployment and help newer portfolios out of the j-curve faster than would be the case for a portfolio consisting of primary funds only.
5. Good risk-adjusted return
What a ‘good’ risk adjusted return is, can, because it is relative and likely individual to each investor, be hard to define, but it is without doubt the best motivation for making a co-investment.
Importantly good risk-adjusted return is distinct from ‘just’ a higher net return, which may simply be a consequence of fee savings, as compared with the portfolio average or all the other individual investments in the portfolio.
And, outside of category, here is a final motivation that is probably often front and centre for investment teams, but is never said aloud
6. LP investment teams wanting to be GPs
This is, in my view, the least valid reason. But is without a doubt for many investment teams, not least those at pension funds with limited upside and downside, a core reason for why CI is very attractive.
Doing CI gets you a bit closer to being a ‘real’ GP. Maybe an argument can be made for carried interest. Maybe the experience will even allow some team members to move to a ‘real’ GP. And, if it goes wrong, your own exposure is highly like very limited.
This is essentially a principal agent problem and, as such, one that investment committees and others tasked with oversight should be very wary about. And, at the very least, look to offset with strong alignment of interest and oversight.
Aside from the sixth, which can never be a valid motivation, the other five motivations are probably often a combination for most LPs. This, especially if the fifth ‘Good risk-adjusted return’ is the starting point, is absolute fine.
What is more critical is that the investment team and, more importantly, the investment committee as well as any investment board or similar is acutely aware of why they are making co-investments.
Once investors have determined their motivation for co-investing, which, all else equal, should be relatively straightforward, the next step is to determine if they have the prerequisite capabilities.
This is what the next post looks at.
* Direct funds include buyout, venture capital, growth, turnaround, balanced and direct secondaries. Source: Preqin, derived on May 15, 2021. IRR is the annualized implied discount rate calculated from a series of cash flows It is the return that equates the present value of all invested capital in an investment (including allocated investment specific expenses) to the present value of all returns (including unrealized returns) or the discount rate that will provide a net present value of all cash flows, plus any residual value, equal to zero. The figures shown relate to past performance.
Blackrock 2022, Benefits and challenges of co-investing, https://www.blackrock.com/institutions/en-ch/insights/investment-actions/advantages-co-investments-private-equity