Co-Investments: A Cooperative Investment Strategy

Deepak Maheshwari

Sanjay Mohanty

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Private equity co-investing is on the rise. A co-investment represents a direct noncontrolling ownership stake in a company—made alongside a private equity firm, or sponsor—rather than an indirect one pursuant to a primary fund commitment. According to research from Blackrock since 2000, over $175 billion has been raised in co-investment funds across a total of 1,101 funds.

In our advisory work and interactions with family offices, PE/VC funds and LP’s investors across emerging markets we are noticing an increasing appetite for participation in co-investments largely enticed by co-investments’ potential for higher expected returns, which is again largely a function of lower fees. A crucial difference between co-investment funds and traditional private equity funds is the economics behind the two transaction types. Studies have shown that under co-investment, the management fee reduces by two-thirds and the carried interest halves compared to investing in a traditional fund.

Do Co-investments Outperform?

According to Hamilton Lane, a US based alternate asset management firm, for every dollar raised by general partners (GPs), an additional twenty cents are deployed in global co-investment opportunities. Investors are using co-investments as a lever to increase allocation to PE and to potentially generate outperformance.

There have been various studies examining the performance of co-investment. Using theoretical benchmark returns, Cambridge Associates, a global investment fund, noted that a portfolio with a 70:30 mix of U.S PE and U.S. co-investments would enhance expected 25-year returns to 14.9% p.a., a significant 1.5% p.a. increase compared to a pure U.S. PE portfolio. In another academic study, Braun et al. (2016) used a large data set which provided 365 observations of buyout co-investments and 615 venture capital co-investments. They concluded:

·???????Buyout co-investments and VC co-investments outperform their corresponding funds

·???????Co-investments generally have lower costs to investors compared to funds

·???????There was no evidence of GP’s offering LP’s lower quality deals on co-investments

One of the leading LP that regularly evaluates and does co-investment is Alaska Permanent Fund. APFC actively sources for co-investment opportunities – as many as 400 deals in a year – and less than a handful of co-investment deals pass through their screening funnel to be approved for investment. The team evaluates and pursues targeted transactions alongside leading general partners. Co-investments enable the team to execute on APFC’s thematic areas in special opportunities and identify targeted exposures to certain geographies, investment types and sectors as they build a well-diversified portfolio.?

Assessment Framework for Co-investments

When selecting investments, it’s important to begin with two key objectives in mind: diversification and a strong fit between the sponsor’s demonstrated area of expertise and the profile of the investment opportunity. Since such opportunities often surface out of a need to deploy capital promptly, potential co-investors must evaluate several factors relatively quickly, including:

?????????????Ownership—Will the sponsor be a capable controlling owner of the company in question?

?????????????Industry—Is the company operating in a growing industry with favourable fundamentals?

?????????????Business—Does the company have a market leadership position and a differentiated product or service offering?

?????????????Management—Do executive incentives and skills align with the interests of investors and the sponsor’s value creation plan?

?????????????Price—Do the valuation, financing, and structure of the transaction represent a good deal with manageable risk?

Co-investments have become particularly popular in recent years as investors have sought to increase their allocations to private equity. Co-investing offers sophisticated institutional and high net-worth investors the opportunity to gain greater exposure to attractive assets and an opportunity to mitigate the PE J curve. While no one can get the economic cycles always right, partnering with proven sponsors that get target selection, due diligence, and transaction terms right helps put the odds of success on the co-investor’s side.