Buyout professionals in northern California looking for a new career opportunity might want to think about widening their search to include the LP community; the California State Teachers’ Retirement System is looking to add 15 people to its team. Their mission? Co-investments.

A similar story is playing out in cities, states and regions across the world as limited partners clamour to take advantage of the “hidden fee break” – and potential alpha booster – that is co-investing.

The opacity of this part of the market makes it tough to get a handle on quite how large it is, but several have given it a try. Cambridge Associates estimates, based on the roughly $20 billion of global private equity co-investment opportunities it saw in 2017, dealflow for the year was around $60 billion. Triago puts “shadow capital” – including co-investment, separate accounts and direct investments – at $189 billion in 2018, of which it judges 29 percent, or around $55 billion, is co-investment capital.

This is not a small amount. Going by Cambridge Associates’ numbers, which estimate roughly $266 billion of capital was called from LPs in 2017, co-investment makes up around 20 percent of overall market activity. For some investors, there are clear-cut reasons for making co-investments. Daniel Winther, private equity and infrastructure head at Skandia Life, sees them as a generator of returns; the insurer’s have outperformed its buyout fund investments by four to five percentage points.

Katja Salovaara, senior private equity portfolio manager at Ilmarinen, appreciates a no-fee, no-carry opportunity but also believes analysing co-investments makes you a better fund picker. The data on a co-investment, she says, tend to be up-to-date, giving a truer indication of the health of an underlying sector or geography than fund marketing documents ever could.

The motivations of many others are less well defined. For some, it doesn’t seem to stretch beyond, “well, we may as well”.

“If an LP has an opt-out, there’s no downside to having co-investment rights,” says Kate Ashton, a partner with law firm Debevoise & Plimpton. “The sponsor promises to bring you opportunities and you can just turn them down as and when.”

The increase in LPs turning to co-investment comes with a palpable change in their risk appetite, a growing willingness to come in pre-close and to share the burden with the sponsor.

Getting in

There are several entry points into co-investing. LPs can follow the example of pension funds such as Canada Pension Plan Investment Board and build large in-house teams to act immediately on opportunities. In January, CalSTRS said it wanted to double the number of co-investments in its $18 billion private equity programme in the next two to five years, hence the goal of adding 15 new members of staff. This is generally the preserve of larger, better resourced outfits.

“In-house teams live and die by the quality of people they can bring in,” says a London-based placement agent. “Competing [on salary] in the open market, against GPs, isn’t a good idea for most.”

A more cost-effective approach is to outsource, generally through a commingled fund or separately managed account. In March, New Mexico Educational Retirement Board, which has $1.85 billion in private equity assets under management, formed a $100 million separate account with Aberdeen Standard to make co-investments in the European small and mid-market.

“GPs will be quick to remember who was there to support their companies and who wasn’t”
Scott Reed
Aberdeen Private Equity

According to several sources, a common fee structure for these vehicles is 1 percent of invested capital from years one to five, dropping thereafter, with carry of 10 percent. This approach not only gives the LP access to the infrastructure needed to diligence deals, it brings in a new network of GP relationships it would struggle to reach otherwise.

Hybrid approaches are increasingly popular. In January, head of private equity at New York City Employees’ Retirement System David Enriquez told Private Equity International his pension was likely to adopt an approach “where [we] could partner with a platform, have a separate account, work side-by-side in due diligence and that platform would be an extension of staff and resources”.

This would help share the burden of co-investing but also give the in-house team the experience and skills needed to branch out alone at a later date if desired.

CalSTRS, with its growing co-investment team, still teams up with advisors to increase dealflow in certain areas of the market. For instance, last year it worked with AlpInvest Partners to target small-cap co-investment opportunities.

Sharing the load

Traditionally, only the largest, most sophisticated LPs have been willing to enter deals at the pre-close stage, with the due diligence and broken deal costs that can entail. The sponsor would assume the risk, (hopefully) close the deal and syndicate it down to a set of co-investors. This is starting to change, due to the growing numbers of LPs equipped to take advantage of opportunities and because the sheer size of deals is forcing sponsors to share the load.

This readiness to commit pre-close could also be indicative of the current point in the cycle. These investors are the ones most likely to be asked for follow-on capital to help support struggling companies when the market turns. This will mean some difficult meetings with investment committees, who will need reassuring that they aren’t just pouring more money into a lost cause. An enthusiasm to take on more deal risk shows long-term commitment.

“All of the ‘tourist’ co-investors that entered the fray in recent years chasing no fee, no carry co-investments that were sure to enhance their PE returns are likely to mount a hasty retreat from direct deals,” says Aberdeen’s co-head of US private equity Scott Reed. “GPs will be quick to remember who was there to support their companies and who wasn’t.”

Do co-investments really generate alpha?

Whether co-investments do indeed boost net performance seems to depend on who you ask. Empirical evidence – and logic – would suggest co-investments as a whole do not outperform fund investments, and there’s some evidence demonstrating they slightly underperform.

But the concentrated nature of co-investments means experience varies widely from investor to investor.

Alaska Permanent Fund Corporation is one of the few LPs to publish its co-investment returns; most investors blend them into total private equity returns. But across the board, LPs PEI spoke to say their co-investments have performed well.

“Our co-investments have absolutely outperformed our regular funds. The deals we have been seeing have outperformed the funds themselves,” says Tamara Polewik, a director in the private equity co-investment programme at Teacher Retirement System of Texas. The TRS’s $5 billion programme began co-investing in 2009 and the strategy accounts for between 20 percent and 25 percent of the private equity portfolio.

The allocation is set to increase to 35 percent, according to Neil Randall, senior managing director, external private markets. Texas TRS is also doubling its team in the next three to five years to 30 investment professionals. The majority of new hires will be supporting co-investment work, Randall says.

The $355.9 billion California Public Employees’ Retirement System reports co-investments with direct investments; the $2.34 billion bucket represents 6 percent of the total and returned 3.4 percent over one year, 17.4 percent over three years, 9.3 percent over 5 years and 15.3 percent over 10 years as of 30 September.

CalPERS’ total private equity portfolio returned 14.8 percent over one year, 10.8 percent over three years, 11.8 percent over five years, and 9.7 percent over 10 years for the same period.

“Due to the concentration of the co-investment/direct investment portfolio, a small number of substantial investments tended to drive performance,” according to CalPERS’ semi-annual performance report for 31 December.

Healthcare of Ontario Pension Plan’s co-investments made up 40 percent of its private equity portfolio and played an important part in bolstering returns in the challenging market environment last year, chief executive Jim Keohane tells PEI.

The 14th largest US pension by allocation to private equity, Massachusetts Pension Reserves Investment Management Board, began its co-investment programme in 2014. It now has 17 investments. The results were blended into the $8.34 billion private equity portfolio, which re-turned a net of 22.6 percent over one year, 18.8 percent over three years, 17.9 percent over five years and 13.9 percent over 10 years, as of 31 December.

However, pinpointing the success of specific investments can be challenging. As Allison Cole, a managing director at Lightyear Capital, a financial services-focused private equity firm, points out, there’s almost no universal reporting.

“If a co-investment didn’t work out, investors probably won’t want to talk about it publicly.”

Indeed, there are substantial differences in co-investment experiences across LPs, according to Josh Lerner, head of the Entrepreneurial Management Unit and the Jacob H Schiff Professor of investment banking at Harvard Business School.

Lerner co-wrote a paper published in February examining the use of alternative investment vehicles, including co-investment vehicles, in private equity by 108 large limited partners over four decades. His research found more sophisticated LPs selected better main funds and the alternative vehicles they invest in perform better relative to the corresponding main funds.

The risks

The rapacious appetite for co-investment is showing no signs of abating: nearly two-thirds of LPs surveyed for PEI’s LP Perspectives Survey 2019 indicated they plan to invest in co-investment opportunities in the next 12 months.

And why should it? Institutional investors are raring to put money to work in private equity, and co-investment allows them to increase the amount, with managers they like at low or no cost.

But if there’s concern that GPs – seasoned investors with experience in company management – may be putting out capital too enthusiastically while times are good and be stung when the market tide turns, what could that mean for limited partners?

There’s certainly potential for LPs to boost their returns through co-investment, but as is usually the case, a higher return comes at the price of higher risk.

In September Per Olofsson, head of alternatives at AP7, one of Sweden’s largest pension funds, warned that those who had bet heavily on co-investment are likely to face a rude awakening if public markets hit a downturn.

“I don’t think we’ve been through a whole cycle yet with co-investments and there are certainly some challenges there,” he told PEI, adding a macroeconomic downturn will most acutely hit the sector.

And what then? Could limited partners find themselves on the hook for extra capital to bail out a sinking business? As PEI’s co-investment roundtable participants pointed out during their discussion in October, LPs that are equipped to make an initial investment decision may not have the legal or monitoring resources to address issues at portfolio company level.

“The follow-up decisions are always the hardest ones,” said Corentin du Roy of HarbourVest Partners. “Do you want to support this investment or let it go? Are you putting good money after bad? That’s where the problem lies.”

The increasing amount of capital tied up in co-investments could be a disaster waiting to happen, but if co-investments come through the next downturn in one piece, that will be a clear signal this part of the market is indeed as robust as it thinks it is, and here to stay.

What makes a good investment partner?
“I don’t think we bring anything to the table apart from cash,” said the alternatives head of a US multi-family office, accosted by a PEI reporter at the Super Return conference in Berlin. It’s a sentiment shared by many LPs that don’t have the resources to enter deals at pre-close. But there are ways to be heard.

A number of LPs with co-investment programmes spoke of the value of being able to offer a “quick no” to opportunities. To get to that point requires a firm idea of the type of deals you want to do and a realistic sense of what you’re capable of, says Andrea Auerbach, global head of private investments at Cambridge Associates, an advisor to institutional investors. If you’re new to the strategy and still working out your processes, be upfront about it.

In a market where every LP wants a piece, it is important to be vocal. The head of alternatives, whose family office has around $3.5 billion in assets under management, keeps a list of companies to which he wants extra exposure and regularly reminds his GPs of the fact. If an opportunity to co-invest arises, his organisation will hopefully be on the shortlist.

Even the largest LPs must jockey for positions. Teacher Retirement System of Texas has a co-investment portfolio worth $5 billion spanning more than 20 managers, around 25 percent of its private equity portfolio. For director of private equity Neil Randall, being a good partner comes down to three questions: “Do we have the organisational processes to make a good decision? Are we able to move quickly? Are we transparent and predictable to work with?”

Patience and flexibility are also required, adds director, principal investments, Tamara Polewik. Due diligence and underwriting can be a messy process and the deal is unlikely to look perfect on Day 1. “You can get into [GPs] heads and understand how they are drinking from a firehose as the deal progresses,” she says.

The balance of power is so clearly in favour of the GP that some strain is inevitable. It is tempting for investors in the syndicate to do their own research on co-investment opportunities or try to critique the GP’s diligence. This can rub managers up the wrong way.

“They are the ones doing the work and taking the risk, so you have to trust their diligence,” is the common refrain. The power imbalance has also led GPs to offer less favourable terms, with some form of management fee and carry becoming common. According to a survey of fees and expenses by sister publication pfm, 40 percent of funds in 2018 expected co-investors to bear a proportion of broken-deal costs, compared with 31 percent in 2016.

One PE head at a Nordic LP quotes another bugbear: GPs packaging co-investments into an overflow vehicle and charging a fee to invest in it, even to existing fund investors. His organisation is in the process of bundling together 15-20 co-investments and giving smaller LPs the opportunity to invest. The vehicle will charge carry but no fees. While the sheer demand for co-investments suggests power won’t shift back to the LPs soon, this could be the start of the fightback.

How Alaska does it
Alaska Permanent Fund’s co-investment programme began with infrastructure in 2012, expanded to private equity in 2013 and went into private credit last year. However, the philosophy is rooted in the work Marcus Frampton, chief investment officer, and Steve Moseley, head of alternative investments, did at PCG Capital Partners more than a decade ago.

Alaska’s $1.58 billion private equity and special opportunities (PESO) co-investment programme has consistently outperformed its fund portfolio, delivering an internal rate of return of 63.4 percent annually since inception five-and-a-half years ago. It returned 47.4 percent over one year as of 30 September.

The six-member private equity team makes a judgment on the underlying investment and the sponsor through its diligence process.

“We are not counting on the GP to make a co-investment decision for us or substituting their judgment for ours,” Moseley says.

Indeed, Alaska’s goal is not to be an investment partner of choice in every situation; it is seeking situations where it is the best fit, Frampton says. As a permanent fund, Alaska has structural flexibility, allowing it to co-invest in opportunities where it can be more than just a capital provider. The team also responds quickly, focusing on “the types of transactions where we can be early and helpful”, Moseley says.

Case in point: its 2017 investment in Premia Re, a specialty insurance investment led by Kelso & Company. Alaska underwrote an equity piece alongside Kelso.

“We were able to tell them fairly quickly that we could invest between $50 million and $150 million,” Moseley says. Alaska ended up investing $75 million, and Kelso brought in another LP who wanted to invest but did not commit earlier in the process. “Our goal was to facilitate the transaction for our own sake and to support Kelso,” Moseley says.
Alaska saw almost 400 deals last year, but quickly ruled out the majority of them.

“Either the circumstances didn’t fit, or it did not complement our portfolio or it was not a GP in which we had a lot of comfort,” Moseley says.

“What made it through our funnel outperformed by a couple thousand basis points,” Frampton adds.

Outside the box
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 entitled 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 725bps. 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.

Don’t just tick the box
Analytics platform CEPRES sees thousands of co-investments. President Christopher Godfrey tells us where they shine

“Working with hundreds of institutional LPs who are active co-investors gives us maximum visibility to the market. Looking to 4,600 co-investments across our clients we see a massive 20-fold increase in participation over the past 15 years. This increase in popularity can be attributed both to investors looking to relieve net fees, but also more active portfolio management.

“Like all investments, co-investments are cyclical and the alpha they bring varies by asset class. Investors should take care not just to ‘tick the box’ and hope for the best. The best performing co-investments certainly come from those who are selective about the deals they participate in and have a qualified team to evaluate. Execution, quality and speed are also critical to success and this can include not only industry knowledge, but also legal support.

“Where co-investments shine is for portfolio construction and risk hedging. Capital in private equity-type funds is generally dispersed because you invest into a blind pool and 75 percent of funds are mixed. With relatively small co-investments, you can significantly increase concentration in single sectors, segments and geographies. We frequently help investors to measure their portfolio correlation and beta risk in both private markets and stocks and bonds, and then can suggest tactical co-invests that are counter-correlated, and thus provide a hedge in case of a market downturn.”

Additional reporting by Rod James and Preeti Singh