Friday Letter: How co-investment will change private equity

A new paper suggests LPs’ desire to go direct will remain a minority sport – but it will be influential nonetheless

It's no secret that at the moment, LPs’ desire for co-investments is substantially outstripping LPs’ ability to execute on co-investments. One LP we spoke to this week enumerated all the features that a successful co-investment programme ought to have – and then suggested the institutions that actually have all these capabilities can be counted on the fingers of two hands.

Nonetheless, it seems likely that investors are going to keep trying to invest a greater proportion of their assets directly, as they look to reduce their costs and gain more control over the risk profile of their portfolios. Which of course raises the question: if LPs are increasingly keen to cut out the middleman, what is this likely to mean for GPs in the medium to long term?

It’s an issue that has piqued the interest of the World Economic Forum’s alternatives group, which in recent months has teamed up with consultancy Oliver Wyman to investigate this emerging disintermediation trend.

One of the key points to come from their research among institutional investors is the sheer difficulty of setting up a co-investment programme, even for sophisticated LPs. Setting up a fit-for-purpose team is not only expensive; it also raises awkward governance, cultural and risk management issues that make it impractical for all but the biggest groups.

Oliver Wyman estimates that of the $70 trillion of institutional assets under management globally, about $6.1 trillion is invested in the kind of alternatives where direct investing is a possibility (so principally private equity, real estate and infrastructure). But if you strip out the capital managed by LPs that don’t have the scale or the set-up to go direct, only about $700 billion of this currently falls into the direct category. A substantial sum, sure – but only about 20 percent of today’s private equity assets, according to WEF.

What’s more, WEF adds, all the constraints mentioned above make it unlikely that this proportion will rise substantially in the near future – because for this to happen, a large number of LPs would have to change their models entirely. If that’s true, and if LP directs remain less than a quarter of overall private equity assets, it doesn’t look like GPs are going to find themselves out of a job any time soon.

What might happen, however, is that more GPs start adapting their models, to try and give LPs more of the upside that attracts them to direct investing. For example, WEF suggests there’ll be a move away from traditional closed-ended funds in favour of more separate accounts and evergreen vehicles, probably with lower fees. And co-investment will become more clearly split between those LPs who want to co-sponsor and/or underwrite deals, and those who just want to pick up a piece of equity post-syndication.

WEF’s glass-half-full take on all this is that it will allow LPs and GPs to “optimise their interactions on specific strategies”; in other words, investors will become smarter about how and when they partner with managers, and the two sides will get better at playing to their strengths. The only problem, of course, if LPs rush into co-investment in the short term and get their fingers burned, they might never get that far…

The World Economic Forum will be writing exclusively for PEI about its new paper in the September issue of the magazine.