One of the big worries about co-investing is that it encourages GPs to pursue bigger deals, taking them beyond what Andrea Auerbach of Cambridge Associates terms the “strike zone”, or their traditional sweet spot for investments.
Research by Auerbach and her team, published in their report “Making Waves: The Cresting Co-Investment Opportunity”, suggests that there are justifiable grounds for concern.
Only about half of the $2.8 billion in co-investment capital invested between 2004 and 2012 landed in the GP’s strike zone of their typical equity size, sector and geography, almost always because they were larger than its typical investment.
Of course, the fact that the GPs are investing in bigger deals – 94 percent of the deals were larger than the manager’s typical investments – doesn’t necessarily mean worse returns.
So the team at Cambridge Associates team decided to look at the returns on 177 deals made between 2004 and 2012. The difference in performance between the “strike zone” deals and those beyond a fund’s normal target areas was stark. Strike zone investments delivered a 1.65x multiple of invested capital, while those outside performed only slightly above cost at 1.02x.
Investors are growing wary of GPs that use co-investments to stretch their investment horizons. One LP who declined to speak on the record noted that it’s usually a bad sign if a GP relies on co-investments for all its deals, indicating that they are constantly going out of their area of expertise.
Aberdeen Asset Management US co-head of private equity Scott Reed is also cautious of deals outside a fund’s typical target: “If a manager expects to routinely be generating incremental equity demands above and beyond that which the fund can speak for, one might argue they’re reaching too hard for larger businesses, going outside of their sweet spot,” he says.
Larger deals may not necessarily mean a fund is over-reaching itself. It could also signal that a GP’s fund is too small for the investments it plans to do and that its next fund should target a higher amount to avoid this reliance on co-investments.
MTS Health Investors closed its third fund, MTS Health Investors III, in 2013 on $188 million. Since the final amount raised was below its target, the firm ended up relying heavily on co-investments for deals in that fund. For its next fund, which closed in early October, the firm was able to close on its $365 million hard cap, allowing the firm to be less dependent on co-investments.
“In Fund III, we were frequently dependent on co-investments because our fund size was not large enough to satisfy the needs of many of our investments,” said Oliver Moses, a senior MD. “There will still be opportunities for co-investors in Fund IV, but we hope to spend less time securing co-investments and more time focusing on finding attractive portfolio opportunities.”
But the advice is still for investors to show restraint for non-strike zone deals: “Beyond the GP’s stated strategy, investors should consider all factors affecting the GP’s incentives in a transaction and whether they align with the timing and prospective holding period of the co-investment offering,” says Auerbach, head of global private investment research at Cambridge Associates.
If this is a concern, lawyers advise addressing it in the fund documents by defining the strategy of the firm as well as the precise deal size and company size it will pursue.