Execution Options for PE Co-Investments

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Co-investments[1], in both private equity and late-stage venture capital, have been a very popular investment avenue for investors globally. Recently, the market has been particularly active; Family Offices and some mid-size institutions, in Asia Pacific in particular, have shown increased interest. Many private banks have used access to co-investments as a way to attract new clients or to keep their existing clients interested with a constant flow of new deals. This heightened activity has, however, not always led to strong investment returns. The pre-IPO space is one of the most extreme examples where many investors wanting to ‘get a piece of action’ on popular names at the peak of the market are now left nursing significant losses on still illiquid names. More generally, high activity in the past few years combined with recently declining valuations in several segments of the market have left many investors wondering whether they should continue to remain active in that space. Our answer is an emphatic “yes” followed by an even more emphatic “but”. This is a material, attractive and growing opportunity to decrease fees and to build diversified private equity portfolios while accessing attractive deals. It, however, requires disciplined investment in resources and capabilities and a level of access and sourcing that is not available to most investors, even sophisticated ones. As a result, a clear execution strategy is required.

Today is a good time to review this issue: there is a wealth of opportunities coming through the desks of investors, and having a clear asset selection framework and execution approach is key to capture the best opportunities while managing risks. We review options for how to do this at the end of the newsletter.

A growing and attractive opportunity for investors

The rationale for co-investments is simple. First, co-investments allow investors to access specific deals that are seen as particularly attractive from a return perspective and allow investors to express high conviction views in a more flexible way than through thematic funds. Finally, co-investments allow investors to ramp up exposure to private equity faster than typical primary commitments to funds – we estimate that the deployment of a PE portfolio could be accelerated by 2 to 3 years compared with allocating solely to primary funds. Ramping up faster with a narrower portfolio may come at the expense of diversification but there are real benefits in being invested faster for longer in terms of overall IRR.

Second, co-investments allow investors to decrease average fees within strategies in which they are already invested. Most deals alongside GPs are fee free (at least free of management fees). Even deals alongside GPs with whom investors are not invested or deals alongside fund-less GPs often carry discounted fees compared to primary commitments (typically 1% management fee and 10% performance fee, or less). Overall, a co-investment portfolio combining both types of deals, with or without fees, would have management fees close to 0% and overall performance fees below 5%[2] and would have a resulting net IRR a few percentage points above an equivalent portfolio built through primary commitments. This makes co-investments a very cost-efficient way to build private equity exposure.

There has recently been an increase in co-investments broadly defined. This includes traditional co-investments alongside GPs, co-investments alongside fund-less GPs, and the emergence of continuation vehicles within the GP-led secondaries market[3]. ?As shown in Chart 1, there has been a sizeable increase in the global co-investment market size including private equity related deals in recent years.

Chart 1: Global Co-Investment Market (US$B) and Share of Deals Involving Co-Investors

Similarly, GP led secondaries have seen significant growth with market volume estimated to have grown from US$23B to US$51B over the past 5 years[4]. We believe that these vehicles will continue to grow as GPs look for new ways to create liquidity events for LPs invested in their existing funds and for themselves. This level of growth is understandable in the current context in the fundraising market — indeed, both the number of funds and the amount of capital raised for primary funds have decreased from their peak in 2022 as shown by data from Pitchbook on Chart 2. This does not necessarily mean decreased appetite from LPs in the longer-term; limited exits have simply left many LPs with limited liquidity to re-deploy into private equity funds short-term.

In this context, investors with available capital for co-investments can benefit from the ability to access private equity at a time when entry multiples are re-setting to some of the lowest levels seen in the last five years.

Chart 2: Private Equity Capital Raising Activity (US$B), US & Europe

Beyond the short-term context and favourable environment, sophisticated LPs have made co-investments an integral part of their private equity strategy and an important tool to build diversified private equity portfolios. It allows investors to reduce fees and to optimise geographic and sector skews in a flexible way. For those investors with specific knowledge or sector specific capabilities, for example family offices backed by a specific operating business, this also allows to deploy sector specific expertise against targeted deals and create post-acquisition operational value-add alongside GPs.

In summary, the combination of increased deal supply, attractive pricing (i.e., lower fees) and improved options for execution makes co-investments a particularly attractive space today.

Requirements for specific capabilities

While the opportunity is real, we have observed with many of the investors we talk to that executing against it can be challenging. Here are some of the pain points and pitfalls that we have observed:

Portfolio design and deployment discipline. Given the opportunistic nature of the co-investment deal flow, there is a real risk that portfolio design could be left to serendipity. A co-investment strategy starts with defining an allocation for direct private investments within the broader investment portfolio of a capital owner; ?this includes for example allocation target, level of diversification (including clear limits on the maximum size of any deal included in the portfolio, typically a limit below 10% for any individual deal though this can depend on the investor’s risk appetite), focus in terms of geography, sector, and stage for different deals. This is no different from building any other private equity portfolio but relies on strong discipline by capital owners rather than relying on the GP. Deployment planning, which we discussed a few months ago in the context of venture capital portfolios (see newsletter ), is particularly important. These parameters should flow into the decision-making of investors and, as we discuss below, should help avoid impulsive or intuition-based decision making. Combining a clear long-term vision for portfolio design with short-term discipline on capital deployment requires a well-defined investment process and good tracking. We have observed that this is very often lacking with smaller investors, especially those not able to dedicate sophisticated, experienced staff to this issue. One particular issue is increased activity at the top of the market – driven by lack of disciplined pacing of deployment. FOMO is seldom a good financial advisor.

Develop diverse and unbiased deal-flow. We have observed that many portfolios, especially those of successful businesspeople, were more a reflection of idiosyncratic, personal networks than of a well thought through top-down strategy for the portfolio. While sourcing from a personal network can have some benefits, individual sourcing networks are inherently biased towards a region or a sector or both. Similarly, the co-investment deal flow itself tends to be biased as similar deals may all lack funding at the same time – e.g., late-stage companies at the top of market. Therefore, high-quality sourcing is one of the most important aspects of building a co-investment portfolio. There is a great risk of adverse selection for all investors, for small and mid-sized investors in particular. Proactive efforts to uncover opportunities beyond relying solely on GP offerings require active outreach, market research, and continuous dialogue across different industry participants; building a differentiated network for deal sourcing and referencing requires time and specialised staff to be successful.

Underwrite and price individual deals. Co-investments require quick decision making. Where GPs will sometimes spend months reviewing deals and pricing them, co-investors may get a few weeks and sometimes only days. Whether investors are asked to commit early on (e.g., via commitment letters where the GP needs committed co-investor funding prior to bidding for a company) or whether the deal is at an advanced stage already, time pressure is most often real. We have seen many investors revert to intuition rather than analysis to deal with this level of time pressure. There is only one situation where this makes sense: this is when you are systematically taking a pro rata share of all your GP’s deals, and thus simply getting a fee discount on a primary allocation decision that has already been made without the potential for generating deal selection alpha. In all other circumstances, co-investors need to develop the ability to conduct appropriate due diligence (even if relying on the work done by the lead investor); doing it under time pressure requires a deep understanding of the industry and of broader market dynamics. Designing a clear decision-making process and strong discipline around it before starting to do deals is critical. One first step is to segment deals – for example, those coming from high conviction GPs vs the others – to find ways to triage deals effectively and fast, but for those who really want to tap the broader market, this simple triage is not sufficient.

Deal terms and deal process. Another challenge is that co-investors must be able to negotiate deal terms and manage the deal process where GPs would normally do all the work. Unlike traditional fund investments, where the fund manager handles most of the investment process, co-investors often need to be actively involved. As an example, co-investors typically need to negotiate the terms of every co-investment with the lead investors — e.g., they would need to negotiate liabilities for broken deal expenses as part of a commitment letter signed early on in the deal process. There is also a difficult trade-off between getting completely fee-free deals and providing enough incentive to the lead investor or to an advisor. This is a nuanced trade-off, which requires a clear understanding of the value add required along the deal process. Similarly, part of the post-acquisition process needs to be managed directly, even if it is most often less demanding than pre-investment for smaller co-investors[5]. We find that very few investors, especially very few Family Offices and small endowments (below US$2B in AUM) have enough capabilities, or simply enough staff, to deal with this aspect of co-investing.

Against this backdrop of increased appetite, increased supply and realisation that deep and specific capabilities are required to succeed, we have seen the emergence of co-investment solutions ranging from co-investment funds (either evergreen or drawdown structures) to structured solutions for investors looking to access co-investment with or without the support of dedicated advisors.

Distinct options to execute a co-investment strategy

Given the mix of opportunities available to investors, we believe that now is a very appropriate time to review execution options for co-investment portfolios. Each option comes with pros and cons and the best choice will depend on the capabilities and resources that different investors can rely on internally.

We have listed a few below from the most to the least complex to execute. Chart 3 reviews these options side-by-side and we elaborate in more detail below.

Chart 3: Options to Execute a Co-Investment Strategy

Direct portfolio of co-investments. This is by far the most complex to execute because it requires building deep in-house direct investment capabilities, including building a team of at least 2-4 staff dedicated to co-investments and allocating significant mindshare and time at the investment committee level. This approach is particularly relevant for family groups that have developed specific skills and networks in an industry and who are able to partner with underlying companies or to take an active role in improving their performance directly or indirectly. However, even very large, sophisticated institutions often delegate sourcing and at least part of the due diligence process to partners and advisors in light of the resource and capability requirements. Therefore, we believe that most investors deploying less than US$100M per year to this strategy are unlikely to have the required scale to execute it well.

Direct portfolio built with an advisor[6]. This is an attractive option for sophisticated investors who either do not have the right amount of resources or do not have the right level of global reach and access. The advisor will support portfolio design, provide sourcing, and conduct due diligence and underwriting. It will also negotiate favourable terms with the GP on valuation, deal structure, governance rights, and fees, which is crucial for optimal risk-reward balance. This approach however still leaves a lot of room to customise portfolios and fine tune allocation, whether it is implemented on a discretionary or on an advisory basis. There is no hard and fast rule to define a minimum annual allocation target to successfully implement this strategy, but it is probably at least US$5M per annum to start and probably closer to US$10M on an ongoing basis.

Vintage based co-investment funds. Over the past 5-10 years, we have seen the emergence of a number of vintage-based Private Equity co-investment funds structured on a drawdown basis. They raise capital every few years, which they allocate over a 12–18-month period. Some come back to market every year, which provides real benefits in terms of vintage diversification and deployment planning for LPs. Compared with fund-of-funds making primary allocations to private equity, these funds can save anywhere between 2 and 4% in look-through fees, which can compound into multiples 20 to 25% higher over 10 years[7]. It is however unlikely that many investors would choose this approach to completely replace primary allocations to private equity funds or to private equity funds-of-funds because this co-investment strategy is typically less diversified. Allocating to one PE fund-of-funds would get look-through exposure (after 10 years) to about a thousand companies. Allocating to one fund of co-investment every year would probably provide exposure to c. 100 to 150 of companies over the same period. Investing in vintage-based PE co-investment funds allows investors to outsource a lot of the pain and pitfalls of co-investment – sourcing and underwriting in particular. It however still requires investors to define a disciplined portfolio deployment plan and to manage ongoing capital calls and distribution. Given this, deploying around US$0.5-1M at the minimum per year is a reasonable starting point to justify these efforts.

Evergreen co-investment fund. More recently, we have seen the emergence of evergreen vehicles to provide access to private equity. Most of them include both investments in co-investments and in LP- and GP-led secondaries. They offer similar benefits to executing through vintage-based draw-down funds (as described above) with two important nuances. On the plus side, they are a more suitable approach to invest in co-investments (and private equity more broadly) for investors with a time horizon less than 25 years. Deploying the portfolio is faster and investors can remain invested longer without having to manage a long tail of illiquid investments typical of drawdown type structures. On the minus side, valuations of the NAV[8] of these vehicles presents some risks inherent to valuing illiquid instruments and often relies on the judgement of underlying GPs and marking agents. While this is not a major issue for very long-term investors, inflows into the fund could dilute existing investors before the value of underlying investments has been translated into a higher NAV and hence decrease their IRR. On a conservative basis, this NAV dilution risk could translate into a decrease in IRR in the range of 1-2% compared with the vintage-based approach to investing in the same co-investments as this would provide cash on cash returns at exits and does not rely on pricing illiquid assets. Compared to an allocation to a fund-of-funds making primary allocations, savings on look-through fees far outweigh this NAV dilution risk. However, it makes this approach more expensive to implement compared with the vintage-based approach described above. Still, we believe that this approach is probably the most suitable for smaller investors or for investors with a less than 25-year time horizon. In recent discussions, we have also observed that large, sophisticated investors who want to optimise their private equity portfolios over time also see this new approach as one other useful tool in their toolbox – e.g., by fine tuning their level of exposure more flexibly over a cycle.

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Seldom have we seen such a buyers’ market for private equity and the surge in both supply and demand for co-investments is one of the consequences. Investors who can define an execution approach that suits their own objectives and capabilities will benefit. Now is the right time to review the options to do so.

[1] Co-investments are direct investments in a portfolio company made by investors (mostly limited partners in funds) alongside the fund sponsor (we focus on private equity in this discussion, but this practice is also common in venture capital or in private debt for example).

[2] Compared to investment in private equity funds, which typically charge 2% management fees and 20% performance fees.

[3] GP-led secondaries involve the fund’s general partner selling assets from the fund. This is different from LP-led secondaries which typically involve the sale of existing limited partner’s stake in the private equity fund.

[4] Evercore.

[5] This would be different for a sizable co-investor involved in post-acquisition operational improvements, which could be the case for large family offices tied to an operational business.

[6] This assumes an advisory rather than a discretionary relationship; no resources are required for the latter.

[7] These estimates of fee savings are based upon certain assumptions which should not be construed to be indicative of actual events that will occur. There is no assurance that the fee savings presented will be achieved.

[8] Net Asset Value.

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