Limited partners are clamouring for more co-investments. The strategy has become ubiquitous, with LPs seeking to blend down fees, form closer relationships with their GPs and flex their diligence chops.
Nearly 59 percent of LPs plan to participate in co-investment opportunities in the next 12 months, according to the Private Equity Investor LP Perspectives Survey 2020. Like its peers the California State Teachers’ Retirement System, Arizona Public Safety Personnel Retirement System and Pennsylvania Public School Employees’ Retirement System, Massachusetts Pension Reserves Investment Management Board has expanded its co-investment programme in 2019.
As part of the expansion, MassPRIM doubled its annual co-investment pacing to 20 percent of its private equity allocation, increased the maximum size of co-investments from $30 million to $75 million, and delegated additional authority to staff when recommending co-investments to the executive director and chief investment officer.
As of 30 June, MassPRIM’s $300 million co-investment portfolio, which started in 2014, accounted for 3.5 percent of the pension plan’s $8.55 billion private equity programme.
Although MassPRIM views co-investment as a tool to increase its allocation to private equity, director of private equity Michael Bailey told PEI dealflow has been “kind of lumpy”, thus reflecting “what the deal business is like”.
At the pension plan’s 26 February board meeting, Bailey said the lumpiness relates to how often private equity firms find an investment, and whether it then fits with MassPRIM’s co-investment programme.
“You are sort of threading a narrow needle,” Bailey said at the meeting.
Still, Bailey told PEI, the pension plan will complete 15 co-investments in the 2019 fiscal year. This was up from 10 completions in 2018, a year in which it rejected an equal number of opportunities.
“We are definitely seeing an increase from last year and co-investments have been scaling, but unpredictable,” he said. “It is a subset of the main fund activity.”
Bailey said the co-investment programme helps MassPRIM get closer to its highest conviction managers and to work alongside them on performing due diligence on investments at the time they go into the portfolio.
“We are making co-investments in funds that PRIM is already invested in,” he said, “so it has given us the opportunity to do ongoing or more frequent due diligence – apart from the deep dive we take when the actual fundraise occurs.”
Bailey added that the strategy also helps MassPRIM manage the costs of private equity: “The net returns are higher dollar-for-dollar on the co-investments because there’s no fee drag.”
MassPRIM has a bench of about 30 high-conviction managers with which it is comfortable co-investing in a total GP portfolio of 100 managers. Firms on the co-investment bench include Thompson Street Capital Partners, Polaris Partners, Providence Equity Partners, Stone Point Capital, Chequers Capital and Waterland Private Equity. The pension system added Georgian Partners in November.
Baily said co-investing gives MassPRIM greater control over investment pacing: “Once we make a fund commitment, the fund manager has the discretion over when to draw down the capital.” On the co-investment side, he added, MassPRIM “can always stop” should the need arise.
The decision to take up a co-investment opportunity is influenced by the tools MassPRIM uses for its manager selection: “Context is critical to evaluating manager skill, so we try to bring a lot of investment opportunities to our internal group discussions so we can compare investments against each other and make a good decision based on the most robust opportunity set.”
Bailey said MassPRIM takes a data-driven and quantitative approach, using objective measures to build an investment thesis on private equity firms and whether they will continue to outperform. “We use those tools to discuss and compare how strong our conviction level is, and what the riskiness of the investment strategy is,” he said. Bailey added that MassPRIM also questions if it is “properly sizing those risks when we make an investment decision”.
MassPRIM does not separately report co-investment performance. However, in aggregate, private equity generated net-of-fees returns of 12.6 percent over one year, 18.7 percent over three years, 16.2 percent over five years and 16.5 percent over 10 years, as of 30 September.