Co-investing is an area in which investor interest doesn’t seem to be abating. There are plenty of ardent proponents of the practice, as well as some vehement skeptics. One thing that seems certain, though, is that co-investment is an ingrained and fundamentally important part of the private markets landscape and a subject that commands ongoing discussion and debate.
Today, we’re observing a more nuanced dynamic at play: Despite the high (and growing) level of interest from LPs in CI, the ability for them to effectively execute a co-investment program is less apparent. In fact, the prospect of doing so can result in a frustrating–and often fruitless–exercise for both LPs and GPs alike.
Private Markets & Co-Investment Activity
Private markets fundraising continues to be strong, despite being off peak levels reached in 2017. Riding that same wave is capital allocated to co-investment.
The increased appetite for co-investment is fueled by motivations and incentives for LPs and GPs alike that are both rational and compelling. For LPs, co-investing provides an opportunity to improve returns through lower overall costs, create faster and more targeted deployment of capital, and prioritize and consolidate overall relationships. For GPs, co-investing enables them to manage fund exposures, expand the size of their target investment universe and avoid partnering with other GPs, which can be difficult situations to manage.
Evidence of these compelling motives gaining traction shows up in the data: According to McKinsey, since 2012 the value of co-investment deals has more than doubled, reaching $104 billion in 2017. Growth and interest has become so apparent that more and more LPs are asking for co-investment opportunities and negotiating co-investment rights as part of their fund LPAs.
Co-investing offers investors the opportunity to achieve attractive risk-adjusted returns. It is helpful to look at investment performance impacted by a tumultuous period like the Great Financial Crisis (GFC) to illustrate this point. The chart below shows that compared to all buyout deals during the same period from 2006 to 2008, the downside risk associated with co-investments appears to be much less, demonstrating the clear opportunity for building a diversified co-investment portfolio with a favorable risk-reward profile.
With the potential for attractive returns, and co-investment demand being evident—and actual investment volume up as a result—you would expect to find many LPs running successful co-investment platforms. But that’s not the case. There are more examples of LPs acting on one or two co-investments versus building a truly dynamic and structured program that can generate the necessary deal flow to yield a diversified portfolio.
What’s accounting for the increased activity and co-investment volume? Dedicated co-investment funds run by institutional managers are generally driving this growth, as their capabilities and resources allow them to be better aligned with the supply side (i.e., the GPs) and deliver on the terms and expectations required by the fund managers offering co-investment opportunities.
Portfolio Construction Considerations
As LPs look into co-investing, it’s important to look at portfolio construction. Co-investing is the same as taking on a discrete, deal risk, which has a wider returns dispersion than fund investing. LPs may subject themselves to more risk because they don’t invest in enough co-investment opportunities to build a diversified portfolio and narrow this dispersion.
There are many ways to look at the risk dispersion issue. Diversification is key, and a properly-constructed, diversified portfolio can provide meaningful downside protection without sacrificing performance. LPs should take this into consideration when co-investing in individual deals. Unfortunately, some do not have the access to enough high-quality deal flow to build a large diversified portfolio.
Timing and the economic cycle are also key factors. Portfolio allocation decisions are important, especially before a recession, which tends to magnify downside risk. But even without including the risk of a recession in the near term, it’s also important to note that the risk of loss of each deal is typically around 30%.
Co-investing can offer LPs a unique opportunity to improve returns through lower overall costs. It creates faster and more targeted deployment of capital and helps to prioritize and consolidate relationships. Yet, co-investing effectively requires an investment in time and resources. It’s not enough to participate on an ad-hoc basis.
Building a successful co-investment platform that can generate strong returns requires access to meaningful deal flow and a structured and efficient investment process that produces sound investment decisions within the GP’s time frame. This is “the struggle.” LPs have the choice to build out their own, in-house platform or invest in a large, institutional manager whose scale can help give them advantages–or a combination of the two. Regardless of what path LPs choose, the interest in co-investing will continue to grow.
Jeff Armbrister is Managing Director, Co-Investment Team at Hamilton Lane