Are co-investment risks fully understood?

Co-investment is rapidly growing into a significant portion of private equity activity, but has yet to go through a whole cycle.

If there’s one market trend we’ve heard more about than any other over the last five years, it’s co-investment.

Both LPs and GPs are, for the most part, big fans: it lessens pressure on GPs to reduce their headline fees, while offering LPs an “unofficial fee break”.

But is co-investment really the way to get the best out of private markets – and could it be riskier for LPs than it seems?

These are the questions we set out to explore in our deep insight feature, published in our June print edition and online this week. We delve into juicy performance data, analyse why a “tick the box” approach doesn’t cut it, weigh up what it takes to be a reliable investment partner and investigate the risks involved.

LPs’ rapacious appetite for the strategy shows no signs of abating: nearly two-thirds of LPs surveyed for PEI’s LP Perspectives Survey 2019 indicated they plan to co-invest with their managers in the next 12 months.

And why should it? Institutional investors are raring to put money to work in private equity, and co-investment allows them to increase the amount, with managers they like at low or no cost.

One of the asset class’s largest investors, the California State Teachers’ Retirement System, is looking to add 15 people to its team to focus on co-investments in a story that’s playing out in similar fashion throughout cities, states and regions across the world.

The opacity of this part of the market makes it tough to get a handle on quite how large it is. Cambridge Associates estimates dealflow for the year was around $60 billion, based on the roughly $20 billion of global private equity co-investment opportunities it saw in 2017. Triago puts “shadow capital” – including co-investment, separate accounts and direct investments – at $189 billion in 2018, of which it judges 29 percent, or around $55 billion, is co-investment capital.

There’s certainly potential for LPs to boost their returns through co-investment, but as is usually the case, a higher return comes at the price of higher risk.

If there’s concern that GPs – seasoned investors with experience in company management – may be putting out capital too enthusiastically while times are good and be stung when the market tide turns, what could increased direct exposure to portfolio companies mean for limited partners?

As one LP told us, the industry has yet to go through a whole cycle with co-investments; a macroeconomic downturn will most acutely hit the sector.

And what then? Could limited partners find themselves on the hook for extra capital to bail out a sinking business? As PEI’s co-investment roundtable participants pointed out during their discussion in October, LPs that are equipped to make an initial investment decision may not have the legal or monitoring resources to address issues at portfolio company level. They may face a tough choice on whether to continue to fund an ailing investment.

The increasing amount of capital tied up in co-investments could be a disaster waiting to happen, but if co-investments come through the next downturn in one piece, that will be a clear signal this part of the market is indeed as robust as it thinks it is, and here to stay.

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