Co-investing is gathering momentum among LPs, but many need to up their due diligence before commiting, according to a study by Boston-based research firm Cambridge Associates.
This investment strategy theoretically offers investors potentially higher returns at lower costs, as long as they have done their homework on what they're putting their money into, the study says.
“There are always good deals out there,” said Scott Martin, director of co-investments at Cambridge Associates. “Better managers outperform, and it's the same thing for deals; you just have to be smart and cognitive.”
The study analysed more than 500 co-investments by about 40 co-investment funds and fund-of-funds managers and found that co-investment returns can outpace returns on private fund investments. In fact, nearly half of them performed better than the sponsoring GP's fund.
Aside from higher returns, co-investments provide investors the opportunity to directly involve themselves with funds and, in turn, work more closely with GPs. The study also cites “J-curve mitigation,” meaning the early period of investments where higher fees and lower returns are typically avoided.
There are some challenges that Martin emphasised LPs should understand before rushing into co-investing.
“As an LP you need to step back and ask yourself, what do you really want?” he said. “We found LPs haven't gone through self-reflection; if they don't do that, they're not going to be successful.”
He said the most surprising finding in the study for him was the simplicity of the reasoning behind firms' underperformance on certain deals.
“When firms step out of their comfort zone, they do deals that are too large, they're dealing with sectors they don't have experience in, [and] that's when they underperform,” he said. “We would've thought it was something more closely tied to academic research, market cycles, [and] having too much leverage.”
Rushing into co-investments may not be a good idea, he said, but when investors are prepared, they can get strong returns and cost advantages through them.