Assessing the co-investment strategy: Perspectives from the field

The co-investment strategy has proven itself to be a popular alternative for private market investors. According to PWC's 2019 Private Equity Trend survey, 82% of LP respondents emphasized that the high frequency of co-investment deals resulted in higher returns. With a surge of co-investment activity and its potential for mutually beneficial outcomes, let's review the possible risks for LPs and GPs.

At the recent IPEM 2020 conference in France, Rishi Kotecha, global head of buyout strategy at IHS Markit, analyzed co-investments as part of a panel discussion.

Here are key takeaways from the panel:

• LPs are involved earlier than ever before in co-investments.
• LPs are involved in add-on acquisitions.
• LPs are setting aside dedicated co-investment funds to improve overall investment portfolio performance.
• GP to GP co-investment, a niche industry, allows the GP co-investment to be a real value add partner.

Co-investment benefits for LPs

Many LPs partaking in co-investment strategies are pleased by the reduction in fees. While lower costs are always a clear benefit, the main driver for LPs to co-invest is to build a better portfolio with the opportunity of achieving higher returns. By partnering with GPs, LPs have greater access to certain industries and regions expanding their portfolio allocation risk profiles.

Justin Wang, leader of European principal investments at Texas Teachers says:

"Co-investments have generated alpha for us not only because of fee savings, but also because of good asset selection. Over time, those factors have helped contribute to the value of our members' pension fund. Additional benefits of co-investments include the opportunity to view our GPs' investment processes up close and through that, we can typically build a stronger relationship from working on deals together."

The add-on benefit for the LP relative to directly investing is their increased confidence knowing that the GP already thoroughly conducted due diligence on the deal, allowing more exposure while leveraging GPs expertise.

Co-investment benefits for GPs

The co-investment strategy provides an opportunity for GPs to build stronger relationships with LPs. With an increasing demand for co-investments, there are better odds for a successful fundraise. Subsequently, providing capital for the GP to access higher ticketed deals, across the portfolio of deals, which in the era of "high" prices, enables the GP to proceed with deals that were previously unfeasible.

Furthermore, the GP gains access to increased resources and a breadth of skills that are leverageable from the co-investor, which enables a heightened opportunity of success.

Gilles Collombin, Partner at Charterhouse Capital Partners says:

"At Charterhouse, we see co-investments as an opportunity for both us and our LPs. The benefit for Charterhouse is that we prefer our investor relationships to work as a two-way dialogue where we pool knowledge to build strong investment convictions. Likewise, from an investor's perspective co-investments are an opportunity to have greater exposure to their high-conviction investments."

Risks for LPs

As with anyone, GPs can make bad investments. When a deal does go bad, how does the interest of the GP and LP remain aligned? In such a scenario, an LP might be asked to front additional capital and have that investment reserve available. The LP most likely has threshold to which it would stay committed, potentially tainting their relationship with the GP moving forward. Moreover, with increased exposure to a single investment, there is a concentration risk should the investment go bad.

Due to LPs general lack of resources and expertise, the short time-frame to evaluate a co-investment deal creates a weighted challenge for decision making. As co-investment is about portfolio investment selection vs. GP managers selection, LPs need to master being successful in both skill sets. LPs typically lack the in-house skill and resources to evaluate the deal, thus the diligence process is somewhat lighter or outsourced.

Wang comments,

"Having the right resources is the most important part of building a successful co-investment program. Co-investments do inherently create a higher level of risk due to having more concentration in a single asset, but that can also be an opportunity to capitalize on, so it is important to have a team that can effectively evaluate deals while keeping up GP timelines."

The balance of the LP primary program may also be impacted, if GPs are selected based on co-invest opportunity, rather than track record and expertise. This can pose a risk for both the LP and GP.

Risks for GPs

The deal process can be delayed. When deals are ready for execution, there is an additional level of due diligence performed by the LP that adds to the timeframe, along with the added cost and resources required.

GPs also run the risk of damaging relationships with other LPs due to potential allocation bias. However, a topical focus for the GP is ensuring that interests are aligned, as co-investment is a business partnership. An LP not being a part of one deal does not necessarily exclude them from the next opportunity.

GPs need to carefully track their investors' co-investments interest and activity, as failure to do so may have regulatory implications as well as difficulties in explaining the co-investment allocation policy to the broader investor base.

Closing Thoughts

GPs are offering more co-investment opportunities as the competitive landscape continues to increase. Co-investment is a key part, almost a must, when it comes to manager attractiveness.

Collombin comments:

"Co-investments are an important part of our toolkit to deliver the balanced and diversified portfolios LPs want. Without co-investments it would, for instance, be much harder to manage concentration risk within a fund and would limit the investment opportunities we could pursue. Ultimately, this is a benefit to all of our LPs as we can develop well-constructed portfolios."

LPs who choose to co-invest need to be diligent when evaluating opportunities and committing to participate in deals, as well as ensuring that it corresponds to their respective portfolio strategy. It is especially important that both GPs and LPs interests and skill-sets are aligned when choosing this strategy. Whether or not this trend will continue to become the norm or if this is an opportunistic period during a peak time in the market, is yet to be seen. For any questions or comments, please contact Rishi.Kotecha@ihsmarkit.com.

S&P Global provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.