Limited partners have expressed concern that an abundance of co-investment capital, driven by challenges in the fundraising market for blind-pool funds, may prompt some managers to stray beyond their sweet spots.
A growing number of firms have been using co-invest rights to attract LPs as the difficult fundraising environment persists. Such investments are highly prized by many institutions as they typically include favourable – or non-existent – economics, boosting returns.
“We’ve seen a lot of GPs saying, ‘Come into our fund, we’ll give you one-to-one co-investment’ as an incentive to the LPs,” David Scopelliti, global head of private equity and private debt at Mercer, tells Private Equity International.
Co-investment capital can be used by managers to acquire businesses that would otherwise breach concentration limits in a blind-pool fund because the stake is too large or the enterprise value too high. Some investors are wary that too much of this capital will encourage GPs to play outside of their traditional segments.
“Co-investments tend to be in those opportunities that are on the larger end for that particular manager, and a key reason that they offer it out is because they’ve got fund diversification rules to manage,” says Steve Hartt, a managing principal at LP consultancy Meketa Investment Group.
“You can see that LP demand for co-investments could push a manager to just doing larger deals that end up taking them out of their strike zone.”
Allen Waldrop, deputy CIO for private markets at Alaska Permanent Fund Corporation – itself an enthusiastic co-investor – says too much co-investment capital “is a risk that LPs should think about”. “Are you investing with a manager that has a $5 billion fund or someone that has effectively an $8 billion fund or $10 billion fund?”
The dynamic, he notes, is more pronounced among large-cap funds. “To me, you’ve made a mistake if you’re going with someone that lacks that discipline. It happens on occasion – you’ll see a larger firm will occasionally do a very big transaction where it’s a $1 billion cheque from the fund and it’s $2 billion of co-investment.”
These situations are less common among multi-product managers with funds targeting a variety of segments, Waldrop adds. “A lot of times in those small and medium funds, they will have to kick any opportunity over a certain size up to the next fund. There is no co-investor in those, because if that deal is that big, then it has to go to the other fund.”
Due diligence
The bespoke nature of co-investment rights makes it difficult for LPs to ascertain how much of this capital is available to the manager. “Co-investment capital has always been on the sideline; it’s hard to quantify, so you don’t really know how much a GP has promised to LPs,” Hartt notes.
As a result, some investors have begun to more closely scrutinise the composition of a fund’s LP base.
“We know how certain LPs act and what they want,” Christopher Bär, managing director at European fund of funds Munich Private Equity Partners, tells PEI, noting that Munich does not participate in co-investments. “There might be situations where we try to triangulate with respective LPs and GPs to get a better sense on the pressure on fund managers to deploy capital beyond the actual fund size through co-investments.”
Another solution can be to examine the existing co-investments a manager has brought to the table.
“I think that that is something that we think about when we’re looking at co-investments that the manager is executing on and trying to make sure that we understand that the keys to creating or unlocking value of the particular asset are similar to their prior experience and results,” says Meketa’s Hartt.
“So, if the way the company is going to grow is international expansion, and that’s not the way the GP has ever done it before, they’re going to have to prove themselves.”
Despite these efforts, LPs are likely to find it difficult to rein in managers that are investing beyond their sweet spot.
“It’s hard to obviously stop the GP; if we turn down the co-investment because we’re concerned about that, someone else could do it,” notes Hartt. “If the deal does not go well and we’re looking at the next fund for the manager, that ‘out of strike zone’ investment is potentially going to be a notch against them.”
What’s more, rampant appetites for co-investments are unlikely to abate. According to Mercer’s Scopelliti, GPs that have become used to offering these rights in a challenging fundraising environment could struggle to withdraw this offering in more favourable climate.
“Once the genie is out of the bottle, you can’t put it back in,” he says. “I think that is a total game changer.”
