Why smaller LPs should add co-investment funds to their portfolio

A white paper from Capital Dynamics shows multi-manager co-investment funds outperform primary vehicles and demonstrate more attractive risk characteristics.

Limited partners should consider making commingled private equity co-investment funds a larger part of their portfolio.

A new white paper from Capital Dynamics has found that not only do multi-manager private equity co-investment funds outperform single-manager primary funds but they also have more attractive risk characteristics.

Andrew Beaton, senior managing director on the co-investment team at Capital Dynamics, told Private Equity International smaller investors, in particular, should consider upping their exposure to such funds; those with larger programmes can likely create the same dynamic through the direct co-investment dealflow they are encountering.

“The co-investment market is probably 10 percent or 12 percent of the total market now. That would suggest at least 10 percent of your investment portfolio should aim to be in co-investment funds if you are a fund investor,” Beaton said.

“We’re going to see co-investment rising as a percentage of the total amount of dollars invested [in private equity].”

The paper analyses 98 multi-manager co-investment funds from 1998 to 2016 vintage years that invest in buyout, growth and turnaround deals and compares it with 2,045 single-manager buyout, growth and turnaround-focused private equity funds over the same period.

It found that 60 percent of co-investment funds outperformed primary funds on a median net internal rate of return basis and 57 percent on a median net TVPI basis. Co-investment funds of vintage years 2009 to 2016 outperformed on both metrics by 80 percent and 71 percent, respectively.

The vast majority of this outperformance is driven by the lower overall costs of co-investment funds, which typically charge a 1 percent annual management fee on committed capital and 10 percent carried interest – half that typically charged by primary funds.

“A lot of the co-investment [activity] has been driven by larger investors demanding reductions in fees, which the GPs, certainly the good GPs, have not given, but they have said, ‘Look, if you do some co-invest on a no-fee, no-carry basis, you’re averaging down your overall cost,’” Beaton said.

“That’s what’s driving more and more LPs to insist on co-investment to achieve that result.”

A typical two-and-20 rate of management fees and carried interest can reduce a gross return by more than 7 percent and the multiple on invested capital by almost 0.6x for a high-performing fund, the paper states. This is reduced by half in co-investment funds. There’s also a shallower J-curve.

Performance may also be boosted slightly by the extra layer of due diligence on co-investments – the first by the lead sponsor and an additional layer by the co-investment manager.

The above, coupled with the fact multi-manager co-investment funds are typically diversified not only by manager but by industry, geography and vintage year, means they also exhibit more attractive risk characteristics. While 13.06 percent of private equity funds for the time period were loss-making, just 8.25 percent of co-investment funds were loss-making.

“With a co-investment fund, you’ve got a much lower chance of a lower return, but equally you’ve probably got a lower chance of a much higher return, other than the return created by the lower fees.”