The problem with co-investing

It is a popular way to cut fees when investing in private equity, but in a downturn co-investment could get messy.

Getting twitchy about the market cycle? “Economists like to say that recoveries don’t die of old age, but they kind of do,” says Steve Rattner, who runs Michael Bloomberg’s family office, Willett Advisors.

After the longest period of post-war economic expansion, it is tempting to expend effort thinking about when the cycle will break. Some – particularly our colleagues in private debt – peek over the edge with something bordering on excitement.

Private equity practitioners tend to be sanguine about the prospect of the inevitable downturn. The asset class has proved well-suited to times of stress; while it may struggle from a relative performance perspective in a protracted public markets bull run, it comes into its own in a downturn.

The industry today is better prepared for stress than it was pre-crisis; managers are better equipped to work with portfolio companies on an operational level (indeed Private Equity International’s Operating Partners Forum New York this week was bigger than ever), covenants on loans are light (allowing them to keep doing so if performance deteriorates) and firms have been busy building up firepower and are continuing to do so. (Download our fundraising data here.)

Is there anything to fear at all?

One area that investors point to with a little concern is co-investment. Last week we heard from Per Olofsson, head of alternatives at AP7. He fears that a downturn in public markets will be most acutely felt by investors which, to reduce their fee burden, have upped their co-investment activity. “I don’t think we’ve been through a whole cycle yet with co-investments and there are certainly some challenges there,” he says.

The value of co-investment deals reached $104 billion last year, according to McKinsey. And more than 70 percent of LPs surveyed by the firm intended to boost their co-investment and direct investment capabilities.  This type of activity is significantly more prevalent now than it was before the global financial crisis.

So how could the co-investment boom come back to bite? Clearly if a limited partner is taking more concentrated bets on individual portfolio companies, they are moving up the risk curve, which could bring some pain. Then there are the constraints in terms of due diligence time and resource (“The GP may have been working on the deal for six to 12 months, and you have three weeks to decide if you want to participate or not,” says Olofsson.)

But these problems are easily addressed; others maybe less so.

In a roundtable discussion last week, PEI gathered six experts in the art of co-investment to share best practice and assess the health of the market (keep an eye out for publication in the next couple of weeks). Amid the general optimism, the one doubt shared by the panel was how certain co-investors would fare when the going gets tough: specifically whether they have the capacity to meet the financing needs of portfolio companies in trouble.

While LPs may be equipped to make an initial investment decision, they may not have the legal or monitoring resources to address issues at portfolio company level, noted one participant: “The follow-up decisions are always the hardest ones. Do you want to support this investment or let it go? Are you putting good money after bad? That’s where the problem lies.”

Let’s be clear – there is more than one way to co-invest. Those investors that mandate co-investment programmes out to third-party managers (as AP7 does) have clearly reduced the risks. Those that decided to enter the market in a big way based on in-house resource may well be tested.

Write to the author: toby.m@peimedia.com