Co-investment: Dancing to a new tune

It would be rare to meet an LP – be it a family office or fund-of-funds investor – that says co-investment is not currently a hot topic. The market is buoyant and the general consensus is that co-invest fever is set to continue for some time.

"If there is no market correction, then we may continue towards a peak," says Tarang Katira, a principal at Hamilton Lane. "Co-investment is the result of selecting individual deals, not funds. What we have seen in prior cycles is, in the couple of years post-crisis, activity drops sharply and GPs become more conservative."

Indeed, after a bumper 2007 of co-investment activity there was a significant drop in 2008 and 2009, Katira says, adding that it has since rebounded to be fairly consistent over the past few years.

According to Unquote Data, since the start of 2014 there have been 21 final closes of co-investment funds, which have raised a total of €8.1bn. This compares with only four funds worth €436m between 2009 and 2013.

Our families look at co-investment as part of their wealth creation strategy and an opportunity to improve the performance of their portfolio" – Richard Clarke-Jervoise, Stonehage Fleming

One reason for the continued interest in the strategy is that family offices have been taking on more co-investments in recent years and are likely to continue to do so, says Katira. Recent examples of such activity by family offices include Capzanine's management buyout of French industrial supplier EOS Corrugated, in which it invested alongside multi-family office Eximium; and the buyout of Corpo Vigili Giurati, in which Italian buyout firm Sviluppo Imprese Centro Italia invested alongside Florence-based family office Next Holding.

"Our families look at co-investment as part of their wealth creation strategy and an opportunity to meaningfully improve the performance of their portfolio," says Richard Clarke-Jervoise of multi-family office Stonehage Fleming. "It is a different approach from institutions for whom a key driver is the ability to reduce the fee drag on their private equity portfolio. They have an affinity with the portfolio company as a means to generating further wealth and getting potentially very outsized returns."

Another factor is that funds-of-funds are raising larger vehicles for the strategy, adds Hamilton Lane's Katira. This year alone has seen Essling Capital, Morgan Stanley and Battery Ventures raise co-investment vehicles to the tune of €115m, €355m and €362m respectively. Meanwhile, last year, HarbourVest Partners closed its bumper Co-Investment Fund IV on its revised hard-cap of $1.75bn, which was increased from $1.5bn due to LP demand.

"Many LPs say they look for co-investments, but the real question is how many can actually execute on it," says placement agent Daniel Roddick at Epic Private Equity. Some LPs have started to set up their own specialised teams dedicated to the strategy, but setting up internal processes is lengthy and costly, says Roddick.

Nascent advisory community
As LPs develop their strategy further, they will have to decide how much they want to continue relying on their GPs' due diligence of target companies, or whether they will do diligence of their own, and set up their own committees, taking the process to another level. Perhaps it is for this reason that some have seen a gap in the market for outsourced advisory services.

Stephan Seissl, formerly of Partners Group, set up advisory business Co-investment Partners at the end of last year to fill that gap, together with three partners, including Hanspeter Bader, former head of private equity at Unigestion.

"Although many institutional limited partners are talking about co-investments and direct investing, at the moment it only works well for large LPs such as Middle-Eastern sovereign wealth funds, which can offer a multi-billion investment in fund or mandate structures in return for preferential access to co-investment opportunities," says Seissl. "Meanwhile if you go down a little in size, both in terms of LP and also transaction size, people still want to do co-invest because of the obvious benefit – as it is a proven approach to not only reduce fees, but also tailor a portfolio – but the average private market investor does not have enough resources to do it."

The overall vision at Co-investment Partners is to help small and medium-sized LPs run a co-invest and direct investment programme that they could not otherwise run themselves, Seissl explains. He says this is part of the ongoing trend of dis-intermediation in the industry, with LPs less willing to pay to outsource wholesale advisory services and instead opting for more specialised ones.

Cottoning on
GPs can also use the strategy as a means to getting access to larger deals than their fund alone would typically enable. "For certain things, where the equity cheque is just beyond what we would be comfortable having as a fund, co-investment is a boon," Rutland Partner's David Wardrop previously told Unquote.

But some LPs say they do not want to invest in a fund where everybody else is desperately keen to co-invest, because they know it is likely to force a GP to pursue larger deals and will consequently mean these investors are differently motivated to themselves.

From the limited partner's perspective, endowments and family offices make co-investments as a way to lower overall fees. And funds-of-funds are able to maximise profit by making co-investments without paying a fee, but then charging their investors a fee thereafter.

However, some industry professionals argue that, with an increasing number of opportunities offered by GPs, LP co-investment is becoming standard and the market could reach a point where it is part and parcel of every deal. Others say that certain GPs are already changing their charging model and starting to charge fee and carry for co-investments, so it may yet transpire that LPs start to question the economics of it.

"It is hard to see why a GP would offer a co-investment for free to someone who was not an existing fund investor," says Epic's Roddick. "We do find, however, that GPs are often prepared to offer co-investment opportunities on a no fee/carry basis during the fundraising period, with the understanding that the LP will commit to its next fund." Ultimately, it is about the relationship, and the economics are for the GPs and LPs to negotiate.

Many LPs say they look for co-investments, but the real question is how many can actually execute on it" – Daniel Roddick, Epic Private Equity

Yet, as the debate regarding the future shape of equity co-investment evolves, limited partners across other asset classes are beginning to follow suit. Just as equity LPs want an increasing slice of the action, the same is true of credit LPs.

A credit co-invest agreement can either be a gentleman's agreement behind the scenes or part of the contract. Whichever form the agreement might take, the strategy is becoming more popular both in the US and Europe. In fact, LPs have been consistently learning about diligence, building out their own direct investment team and developing a strategy, say direct lenders.

A credit co-invest essentially works in the same way as an equity co-invest. The LP in question invests in a direct lending fund and when that direct lending fund provides the debt for a private equity buyout, the LP may be invited to take a co-invest slice, thus boosting returns.

"We have been seeing an increased level of sophistication with a significant number of credit LPs, many of which have formed their own direct lending teams," says Thomas Duetoft head of origination at private debt firm Pemberton. "Co-investment can take the form of an SMA, where the credit exposure is managed by the asset manager, or be on the balance sheet as some LPs are keen to book the exposure directly and be a lender of record.

"Typically, if an asset manager lends to a borrower – as part of the NDA process, there is an agreement in place with the borrower that the asset manager may open up the opportunity to an LP once everything has been signed. The borrower is generally always made aware of the identity of the potential incoming LP lender."

In the smaller mid-market, the size of the deals do not always necessitate, or allow for, a credit co-invest, as is sometimes the case on the equity side, explains another direct lender. But larger institutions are often very keen. "There is increasing appetite to do deals as a co-invest and it is something we get asked about a lot by LPs," he says. "But there is also a high dropout rate."

Head to head
On the equity front, some believe the rise of co-investment will morph into more direct investing by LPs, especially by some of the larger LPs and funds-of-funds. "At the top of the market, some LPs are well positioned to compete directly with GPs and also, at the micro level, there are family offices who know that small end very well," says Hamilton Lane's Katira. "In the mid-market, it is more difficult. Very often it comes down to whether a firm has the resources and skillset to source attractive deals."

"You may get more LPs wanting to do a greater proportion of direct investments," says Clarke-Jervoise. "But this will always remain a small group of people, as most are cognisant of what a formidable task it is and the work involved."

As it stands, even at the co-invest level, the number of professionals is much lower than the number of people interested. "The vast majority of institutional co-investors are opportunistic ones," says Co-investment Partners' Seissl, adding that they usually have less than 10 positions, built up over several years. "Very few people in the market have a systematic portfolio of co-investments of substantial size, built up following a clearly defined investment strategy. Roughly a third of those institutional LPs who do co-invest have a sizeable, systematic portfolio, with the remainder only looking at potential transactions when there is resource available."

And although more funds-of-funds are being raised for the strategy, they still must show their LPs that they are relevant and have access to the GPs and their deals. "You have to prove to your investors that you will be given the opportunity," says Seissl.

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