Thinking outside the box on co-investment performance

Josh Lerner, head of the entrepreneurial management unit and the Jacob H Schiff professor of investment banking at Harvard Business School, co-wrote a paper published in February titled “Investing Outside the Box: Evidence from Alternative Vehicles in Private Equity” examining the use of alternative investment vehicles – including co-investment vehicles, feeder and parallel funds – in private equity by 108 large LPs over four decades.

The main takeaway? There is no evidence these vehicles outperform the corresponding main fund. “LPs typically assume that these investments, because they have lower fees and carry, will automatically be better investments than funds. But the answer, using a comprehensive database of activity of 108 of the world’s most significant LPs, is no,” Lerner says.

The paper found substantial differences in experiences across LPs. The more sophisticated, with better past performance, see better performance in their alternative vehicles. “Not only do they invest in better main funds, but the alternative vehicles they invest in do better relative to the corresponding main funds. They are just better investors,” Lerner says. “The analysis suggests the proliferation of co-investment opportunities may be beneficial for the most sophisticated LPs. But for the typical LP, it is far less clear that this is ‘good news’.”

A paper by Cambridge Associates also stresses that, due to the concentrated nature of co-investments, individual outcomes are wider than for fund investments. However, Cambridge suggests the fee-reduction benefits of co-investments alone can have a significant effect on overall return: analysis of its database finds the average difference between gross company-level returns and net fund-level returns for a US private equity fund is 725 basis points. A representative private investment programme with 20 percent exposure to co-investment could capture 100bps in excess return just from fee savings.

The conclusion? LPs should at least retain the option to pursue co-investments.