As discussed in the last post, ‘The motivations for co-investing’, co-investments are attractive for several reasons. But mainly because they potentially have a higher risk adjusted return and can add diversification to the portfolio.
But instead of a deliberate and rigorous co-investment selection process many investors simply focus on whether they are already invested with a GP and / or if they can get money out the door.
Especially now that the bull-run of the last decade-and-a-half has ended, this undoubtedly leads to a poorer risk adjusted return – even if the co-investment is ultimately successful.
Figure 1: Probably a poor approach to co-investment opportunities
To at increase the probability of a successful outcome and a better risk-adjusted return, more is required than just the opportunity and capital
Alignment with portfolio construction
Sufficient resources
Strong processes
Ability to move at speed
Good relationship / reputation with GP
These points are obviously interrelated and will collectively help increase deal flow, mitigate risk, and make the investor more attractive to GPs looking for co-investors.
This rest of this post looks at each of these capabilities.
Co-investments should be aligned / integrated in overall portfolio construction
With every co-investment, very specific vintage, stage, sector, and geographic risk is implicitly added to a portfolio. This makes it critical that the co-investment is 'correctly sized' relative to these factors and the overall portfolio to avoid unwanted bulk risk.
Nonetheless, this is seemingly often overlooked / forgotten by LPs. And even though this may also have had something to do with the previously mentioned bull-run, it is also because many LPs simply have neglected developing the prerequisite co-investment capabilities.
Doing so is critical as it increasingly will allow LPs to be proactive and selective, rather than reactive and takers, in their approach to co-investments and through this integrate the co-investments in their portfolio construction.
Resources go far beyond the ability to write a check
Contrary to common perception, capital to participate in a co-investment is simply a starting point. If the focus, as it should be, is risk-adjusted returns over getting money out the door, then human resources are significantly more important than the ability to write a check.
To increase the probability of a good outcome it is critical to have a well-resourced investment team alongside legal, tax, and operations specialists. They must have the knowledge and experience needed for co-investments, work well together, and have strong alignment of interest.
Notably, sufficient resources are not initially a factor of the absolute size of an investor’s investment programme. Rather, whether investing very little or a lot, there is a bare minimum of resources that must be in place to adequately do co-investments. Obviously, as a co-investment programme grows, resources must grow correspondingly.
This means that for most investment programmes there is a minimum size at which point critical mass is reached, and where it now makes sense for investors to begin to consider doing their own co-investments. While it will vary by investor, this point is probably at least USD 50 - 100m or more a year.
Strong investment and governance processes to ensure good selection
First and foremost, the investment process must be well-resourced, streamlined, and rigorous. This ensures that ‘poor’ investments opportunities are screened out fast at the top of the funnel, and that time and effort is spent on the more promising opportunities and getting these to the finish line.
The investment process should, without undue interference, in turn be overseen by a strong governance process. This would typically be an investment committee or similar that ensures that the investment process is followed, that the best co-investments are selected, and that they fit with the overall portfolio construction.
Ability to move at speed
Co-investments, whether as part of a co-underwriting or a syndicate, are increasingly competitive.
Thus, the ability to move at speed and meet tight deadlines, which are closely related to resources and processes, are critical to secure both investments, if part of an underwriting, and allocations, if part of a syndicate.
Good relationship / reputation with the GPs
GPs do not want to lose investments or struggle to syndicate a co-investment piece and naturally pre-investment place a high value on speed and certainty. Post investment it is important that LPs can follow-through as and when needed. For example, many co-investment LPs were seemingly caught off guard when they in Q1’20 had to find more capital to support their co-investments during Covid.
An LP's ability to deliver on these things is largely based upon the prior points and helps make the LP an attractive co-investment partner alongside building a good reputation and relationship. Without this, LPs, no matter their size, will likely struggle to get in on the best co-investment opportunities, or at least face a greater adverse selection problem.
Co-investments are riskier than fund investments
This should not come as a surprise for investors and underscores the necessity of building diversified portfolios not just across vintage, stage, sector, and geography, but also across GPs and deals.
Nonetheless, for various reasons, many LPs approach co-investments on a case-by-case basis. Exactly how risky this approach can be is clearly illustrated in Figure 2, where loss ratios on realized buyout deals is approaching 30%.
Figure 2: Loss ratios of realized buyout deals
Source: Hamilton Lane, 2019
Note: Past performance is not indicative of future results
The key to offsetting this single deal risk is the ability to be highly selective by generating sufficient deal flow and, as noted, constructing a well-diversified portfolio that can provide downside protection.
Most LPs should consider outsourcing their co-investments
Aside from requiring a significant investment programme, to make it worthwhile developing the capabilities to execute co-investments, building a platform for co-investing is typically both time-consuming and costly.
Consequently, many LPs, regardless of size, may be better off outsourcing their co-investments to a specialised manager that can execute more efficiently at scale.
For those LPs who want to build an in-house programme the next step, after having developed the prerequisite capabilities to do so, is to start assessing co-investments.
How to potentially do this is the topic of the next post.
Stay illiquid!
Kasper
Sources:
Hamilton Lane, 2019, https://www.hamiltonlane.com/en-US/Insight/Co-Investing-Struggle