Team spirit: the enduring appeal of co-investment

Fundraising for co-investment strategies has reached a new high: with €7.87bn collected across seven co-investments funds, this year has the highest value collected across such vehicles ever recorded by Unquote Data. Bumper vehicles included Ardian's Co-investment V, which launched in Q1 2017 and closed in October on $2.5bn, more than doubling the size of its predecessor. This is the largest final close of the year for a co-investment fund, followed by US-based Hamilton Lane's $1.7bn Hamilton Lane Co-Investment Fund IV (which also invests in Europe), Advent's €1.7bn Global Technology fund, and LGT Capital Partners' £1bn Crown Co-investment Opportunities II.

Ardian's head of co-investment, Alexandre Motte, says there is plenty of appetite for the strategy, to the point that the GP decided to surpass the fund's target of $1.2bn while on the fundraising trail: "The strategy of co-investment is more visible compared with a few years back, and investors are attracted by the lower risk and diversified exposure of the strategy, as well as its lower fees and carry. This was particularly the case for some insurance companies, pension funds, and family offices. As a result, we have been able to expand our investor base."

Fundraising for the strategy has grown consistently, with 36 final closes of co-investment funds with a European or global strategy since the start of 2016, raising a total of €21.1bn, according to Unquote Data. This compares with €6.67bn raised across 14 funds in the prior four-year period between 2012-2015.

Secondaries interest
In addition to this fundraising bonanza, co-investment-focused GPs are also having to contend with growing competition from other players, chief among them secondaries funds. The secondaries market keeps growing, with Triago's latest quarterly forecasting a new high of $90bn in 2019 transaction volume. With so much capital being invested in secondaries, investors are coming up with creative ways to allocate. "A wrinkle on the traditional co-investment that secondary specialists are pursuing are single-asset fund restructurings," says Mathieu Drean, Triago's global head of secondaries. "Unlike a classic co-investment, the fund is usually selling out of the asset in such restructurings. Yet, just as in a classic co-investment, the GP is the asset's active manager, with the LP – in this case the secondary specialist – investing in the asset."

Says Philippe Poggioli, managing partner at Access Capital Partners: "It has become increasingly frequent to see pools of secondaries investors investing alongside a GP that maintains a majority stake. Many such transactions are intermediated by secondaries advisory firms. Previous owners would typically charge discounted fee and a carry (if not full price) to the secondaries backers."

The no-fees, no-carry arrangement is not typically set out in these types of co-investments and given that the investment period is that of a traditional buyout, secondaries co-investors do not provide returns to their LPs as quickly as with more classic secondaries transactions. However, these investments can provide a higher possibility for value creation, since the investment lasts longer, so the multiple generated from the sale – over 2x typically – is more attractive than the normal 1.3-1.5x multiple seen in more standard LP secondaries transactions in the current market. Poggioli expects the number of such transactions to increase significantly in the near future.

It has become increasingly frequent to see pools of secondaries investors investing alongside a GP that maintains a majority stake" – Philippe Poggioli, Access Capital Partners

First-time partnerships
Another factor that helps fuel the sustained rise in co-investments is the number of first-time funds currently coming to market. Stephan Seissl, co-founder of Co-investment Partners, says that, as institutional LPs' commitment sizes have increased, capital availability from institutional investors for first-time funds has mathematically decreased. Emerging sponsors thus tend to follow a model where a deal-by-deal funding approach is deliberately chosen ahead of an institutional fundraise, often within a co-investment setting.

Seissl says his firm is aware of around 75 first-time GPs across Europe that hope to build a seed portfolio ahead of formally attempting a fundraise. "Having completed two or three acquisitions thanks to deal-by-deal co-investments, these GPs will have a track record to talk about and those co-investing LPs might then back the GP's maiden fund," he says.

Co-investment funds, therefore, sometimes take the lead in backing new GPs, although there are some difficulties in the process. Essling Capital co-head of PE co-investments Alexander Cuniasse says: "Potential co-investors need to make sure their interests are well aligned with those of the sponsor, and to understand who will manage the asset should the fundraising fail." Pure co-investment funds may have a series of restrictions around which lead investor they can back.

Several sources agree that backing debut funds is also a strategy eyed by secondaries funds, given their typical flexibility when it comes to asset allocation.

Access Capital Partners' Poggioli agrees that funds-of-funds and, to a lesser extent, secondaries funds have not been reluctant to co-invest alongside first-time-funds. For example, Access co-invested alongside Tenzing Private Equity when acquiring HR software developer FMP Global in 2016. The deal was sourced by Tenzing, and Access provided the capital. The business was sold in August this year, with the sale generating a money multiple of 5.4x and an IRR of 72%.

In these types of investments, an extra layer of complexity is added, as governance, a full understanding of the investment thesis and due diligence results are even more important. "This market is getting more established, but we do not yet feel it is too crowded. The added complexity and proximity to the portfolio company is not for everybody," says Co-investment Partners' Seissl.

Some of the largest transactions in Europe in recent months have included co-investments, as private equity firms punching above their weight enlist help from LPs wearing their direct-investor hats. EQT and the Abu Dhabi Investment Authority notably acquired Nestlé Skin Health for an enterprise value of €8.9bn in May 2019, while KKR and Canada Pension Plan Investment Board took Axel Springer private in a €6.8bn deal in August.

LPs committed to our fund-of-funds are keen to continue backing the best startups in our portfolio. Co-investing allows them to join in a more direct fashion as companies mature into later stages" – Joe Schorge, Isomer

Starting small
Co-investments are equally flourishing in smaller segments of the market. Says Essling's Cuniasse: "Mid-market GPs are also increasingly offering co-investment opportunities to fulfil the growing appetite of their LPs, which highly value the optionality and the reduced economics". He adds that GPs also need to demonstrate their ability to invest in larger targets in anticipation of raising a larger successor fund. LPs backing the mid-market are following the steps of their large-cap counterparts, as they get more sophisticated and more willing and able to select deals by themselves. "After investing in funds-of-funds and then in funds directly, co-investment is the last step in their learning curve before a direct approach," says Cuniasse.

Ardian's Motte agrees, saying that more mid-market GPs target companies with higher valuations than usual, knowing they can rely on co-investment appetite from their own LPs or dedicated funds. Ardian Co-investment IV notably backed Emera alongside Naxicap in July.

A more recent development that shows how normalised co-investment has become is in the venture space, driven by LPs' appetite to back the best-performing startups. Examples of funds targeting that strategy include Fundo 200M, a €200m co-investment vehicle managed by PME Investimentos that backs co-investments in Portuguese startups. Isomer, a firm founded in 2015 and specialising in VC funds-of-funds, is also looking to raise a late-venture co-investment fund, called Isomer Opportunities. Isomer managing partner Joe Schorge says: "LPs committed to our fund-of-funds are keen to continue backing the best startups in our portfolio. Co-investing allows them to join in a more direct fashion as companies mature into later stages." The idea is that when backing the co-investment fund, LPs could take part in later funding rounds, essentially jumping the queue for access to attractive valuations, helping companies grow and getting exits earlier than possible with a purely early-stage focus.

Once regarded as a box-ticking fad, co-investment strategies have made strides when looking at appetite on the fundraising side, the appeal to new categories of players, and growing activity across the value spectrum. This normalisation is compounded by the current competitiveness of the private equity investment landscape on the buy-side: at a time when being able to arrange co-investment quickly can help push GPs over the line in heated processes, going solo can put managers at a disadvantage. Nevertheless, the longer-term challenges that have been associated with co-investment from the start remain front of mind for GPs and LPs alike. The latter, in particular, will be wary of the ramifications in a potential downturn. But the potential upside continues to outweigh these concerns, with mitigating tactics including careful partner selection in the first place, as well as maintaining discipline when it comes to diversification at portfolio level. 

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