Developing a successful co-investment program

Background

Preqin, an alternative assets analytics firm, recently published research indicating that 77% of private equity investors pursue direct investments into companies alongside general partners (co-investments) on an active or opportunistic basis. Further, a Cambridge Associates study indicates that co-investments account for roughly 5% of overall private equity investment activity. Co-investment activity has increased and is expected to continue for the reasons below:

  • There is an increased amount of capital directed towards alternative assets driven by higher institutional asset levels and increased allocations;
  • The required equity contribution by a single sponsor is increasing as sponsors look to limit the number of other managers with whom they partner; and
  • LPs are seeking to manage their portfolios more proactively.

Benefits of establishing a co-investment program

  • Greater control over capital deployment: Co-investments generally have shorter deal cycles with capital drawn at once rather than over time, allowing the LP to accelerate capital deployment in order to increase the private equity allocation.
  • Flexibility in investment selection: Co-investments may be selected on an individual basis, providing flexibility for investors to capitalize on current market conditions and diversify their portfolios through targeting attractive strategies, sectors or geographies.
  • Lower overall fees: Co-investments often come with low or no management fees or carried interest to the manager, thereby enhancing net returns for the LPs.
  • Deeper relationships with core managers: Investors may leverage existing manager relationships for deal flow. Participation in co-investments may deepen relationships with the manager and improve the LP’s understanding of the manager’s investment process.
  • Satisfy LP-specific objectives: Co-investing provides investors greater flexibility and control to avoid certain sectors or gain more exposure in attractive sectors than blind pool commingled funds.

While there are benefits to LPs, there are also a number of factors that should be considered as investors evaluate their approach to co-investments.

Factors to be considered

  • There needs to be an appropriate match between the skill set of the team and depth of resources to source and evaluate opportunities. This is critical as the skills required to evaluate an individual investment are significantly different than those required to evaluate a fund.
  • The approval process must be structured to support more rapid timelines and manage potential issues around confidentiality that result from investing directly into a company versus a commingled fund. Co-investments typically require a much shorter timeframe from initial screening to close compared to fund investments. It is sometimes difficult to anticipate when exactly they will move forward. Further, the requirements of certain LPs with regard to transparency and disclosure (i.e., presenting at a public meeting, distributing materials to a board) can present issues when making company investments.
  • Investing directly into businesses increases headline risk relative to fund investments. Successes/disappointments tend to be apparent earlier in the investment cycle relative to fund level commitments. Unlike commitments to funds, LPs are associated more closely with the activities of a company because they are investing directly into the business rather than through a fund. Further, co-investments draw capital at closing and have a three- to five-year life, during which valuation changes occur more quickly than a fund commitment.
  • Leveraging the existing manager relationships within the investor’s “core portfolio” of alternative investments is critical to the sourcing and screening process. Understanding the managers’ strengths and weaknesses with respect to their investment process, approach and historical track record across different investment types ensures that LPs focus on the right investment partners. This analysis, along with developing a portfolio management approach to a co-investment program, will enhance deal flow and help LPs avoid “adverse selection”—one of the key risks in building a program.

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