Appetite for co-investment remains high, with almost two-thirds of investors planning to invest directly alongside their GPs over the next 12 months, according to Private Equity International’s LP Perspectives 2022 Study. “Demand for co-investment has continued to increase year-over-year from both sponsors and investors,” says Craig MacDonald, a managing director in HarbourVest’s co-investment team.
The appeal is clear: access to top sponsors, enhanced diversification, pre-screened dealflow and reduced fees and economics, according to fellow HarbourVest managing director Corentin du Roy.
“Co-investments can offer participants diversified exposure to high-quality deals at favourable economics,” adds David Brett, partner and head of co-investments at Adams Street Partners.
“We have seen co-investment move from being a nice-to-have to an essential requirement for many limited partners,” says Bart Molloy, partner at Monument Group, who adds that increased appetite is leading many GPs to think carefully about how they manage their investor base.
“Managers want to have some LPs who like co-investment, but not every LP, because otherwise they run the risk of not being able to deliver on the co-investment they have promised. GPs are seeing value in being tactical about who they have in their fund.”
But while there is pressure on GPs to deliver co-investment to their investor base, there is also pressure on LPs to execute on the co-investment appetite they have indicated. Molloy says that deeper co-investment experience has led to greater sophistication within the LP community. “LPs are definitely getting better at being quick to respond. They know they need to be efficient in providing an answer,” he says.
Despite this increased sophistication, insufficient staffing is the most frequently cited factor hindering co-investment participation. The speed required to progress with a transaction is also a concern. “The elevated volume of opportunities can present challenges with respect to effective deal triage and team capacity for those participants not employing adequate resources or maintaining a dedicated co-investment infrastructure,” says Brett.
Jennifer Choi, managing director of industry affairs at the Institutional Limited Partners Association, agrees. “Despite increased appetite, not all LPs have the ability to participate, due to capacity or capital constraints, including the need for specialised expertise to quickly arrive at a decision on whether to invest, which GPs deem a critical ingredient in identifying partners of choice,” she says.
ILPA is working to help LPs shorten the decision-making curve through a new ILPA Institute educational offering that covers how LPs can optimise their ability to take advantage of co-investment opportunities. “The new course, offered virtually for the time being, is selling out in North America, Asia-Pacific and Europe,” Choi says.
A lack of available co-investment opportunities, meanwhile, was also considered to be an obstacle. “Obtaining the desired allocation from the lead GP in a co-investment deal can be a challenge,” says Brett.
“Differentiating yourself as a co-investor continues to be a challenge for many participants in the market,” agrees MacDonald. “Because there is so much appetite from various sources for co-investment, we have also seen more sponsors looking to consolidate the number of co-investors they bring into a transaction in order to better manage their process.”
Furthermore, despite feverish appetite, co-investment is not a panacea and it is clear that deal selection is paramount for investors contemplating the strategy. The Church Commissioners, for example, will only invest alongside its most highly rated managers.
“That is because we rely on the GP’s due diligence process in order to opine on the deal, given that we typically have somewhere between two and six weeks to confirm interest,” says Roy Kuo, head of alternative strategies for the Church Commissioners, which manages the Church of England’s endowment.
Even among its own managers, the Church Commissioners only moves forward on a little over half of the deals it is shown. “That is because our analysis shows that if a co-investment is not in the manager’s sweet spot, it is likely to underperform the greater fund,” says Kuo. “We only co-invest on deals that are in the absolute core of what that manager does.”
Previous cycles have shown that a co-investment strategy is not without its risks. “Robust deal volume and strong returns have resulted in increased appetite from traditional co-investors and have attracted various new entrants to co-investing,” says Brett. “But, if history repeats itself, many of the less experienced or newer entrants could suffer in a downturn and either stop or reduce their commitments to co-investment opportunities, which may provide more opportunity for the longer-term consistent co-investment providers.”