Despite a deluge of dealflow in the co-investment space over recent months and years, co-investors are – understandably – being more selective than ever.

“We have always been very consistent in the pacing of our funds – a discipline reinforced by the GFC – and we have continued to invest through 2022,” Craig MacDonald, managing director of HarbourVest, told affiliate title Buyouts at the end of last year. “That said, we have certainly said no to more opportunities than we have historically.”

Co-investors are particularly wary of overpaying and are reluctant to take a slice of what James Pitt, a partner at Lexington Partners, describes as “yesterday’s deals”. Pitt adds: “We are all trying to avoid deals that were priced a while back.”

In particular, co-investors are looking for businesses with strong pricing power and a good degree of locked-in revenues that are well placed to weather a recession, Pitt says. He adds that Lexington is also focused on ensuring that appropriate capital structures are in place.

“We’ve applied some lessons learned from the GFC to our underwriting approach. Many buyouts done between 2006 and 2007 were priced at peak valuations and generated limited free cashflow to repay debt in the first year or two, posing challenges heading into the recession,” says Andrew Farris, managing director at BlackRock Private Equity Partners.

“Many of those deals were longer holds and faced multiple compression at exit as valuations reverted towards historical norms,” Farris continues. “In recent years, we’ve been conscious of the parallels to the pre-GFC environment, with buyouts again being done at heightened valuations and leverage levels. Our underwriting has emphasised free cashflow, potential multiple compression and recession impact.”

Inflationary pressures

Alexandre Motte, managing director and head of co-investment at Ardian, also sees echoes of the last financial crisis in the current environment. He believes that leverage and the ability to pass on inflationary price increases are two of the most important considerations today.

“Our experience in the last crisis showed that if debt levels are too high or if the right covenants are not in place, that significantly increases the risk of running into trouble,” he says. “We obviously also want to ensure that a company can pass price rises on. That means investing in businesses that sell products and services that are essential to their customers.”

Although those fundamentals can exist in any sector, certain industries are proving more popular with co-investors than others: tech continues to be a major theme due to the defensibility of the product, protection against inflation, and strong cashflows. MacDonald also believes that financial services will become an increasingly interesting theme as a result of rising interest rates.

Motte adds that healthcare is inevitably becoming hot property, largely given the commonly held assumption that healthcare spend remains a priority regardless of the macroeconomic context. He sounds a word of warning, however. “Governments… paid whatever was required during covid, but that may not necessarily always be the case.”

And while Motte acknowledges that the consumer goods sector is challenging, based on the confluence of supply chain disruption and a severe tightening on discretionary spend, he adds that pockets of opportunity remain. Ardian, for example, has invested alongside 3i in discount retailer Action.

“That is a company that is performing very well because of its low price point,” Motte says. “We don’t necessarily take a sector approach. We focus on understanding where a company is positioned in the value chain.”