Co-investment: get out or double down?

The past few years have seen co-investment on the rise, with LPs eager to share in the upside of continued PE outperformance. But the robustness of an investor's co-investment strategy is being put to the test this year in light of the difficult social and economic conditions in the wake of Covid-19, with some questioning whether this will lead LPs to rethink their strategy.

Research from Cambridge Associates estimated co-investment value to have amounted to $60bn in 2017, equivalent to 20% of overall private equity investment. This is part of a long-term trend and, although reliable data is hard to come by, the number is likely to have risen since then.

"In a bull market, it is natural for investors to want to double up on something that seems to be a success," says Stephan Seissl of advisory firm Co-investment Partners. "But when the market turns, unlike in a fund you are not protected by your maximum commitment level in a co-investment. "In the latter phase [of a positive cycle], co-investments become very fashionable because investors tend to hear success stories. Experienced managers tend to keep 15-20% of a co-investment fund in reserve in order to be able to support companies and thus protect their investments in a downturn."

Feel the pain
What is clear is that just as LPs will benefit from being closer to the asset when the going is good, the same investors will equally suffer when a portfolio company takes a hit. And at an unprecedented juncture like the coronavirus pandemic, limited partners that have double exposure – through both fund and direct investments – to sectors such as casual dining, physical retail spaces and travel have felt the pain as much as their GPs.

Active co-investor CPPIB – with half of its $95bn allocation to private equity invested in direct and co-investments – is one. The LP has a direct stake in Hotelbeds alongside private equity houses Cinven and EQT, and undertook a €430m capital injection for the company in April, alongside its fellow sponsors. The group suffered a massive and sudden drop in volumes earlier this year as the accommodation sector ground to a halt due to lockdowns worldwide.

But Hotelbeds is not alone and there has been no shortage of private-equity-backed companies in need of a helping hand in the form of new money.

Others include UK-based oilfield services group EnerMech receiving £50m in new money from sponsor Carlyle and its lenders in July. EQT also looked to shore up liquidity for its Danish hearing aid provider WS Audiology by raising €150m in new money during the pandemic, as well as agreeing to inject new equity worth €50m into Dutch dental chain Curaeos Covid-19, which all but shut down its operations, according to Unquote sister publication Debtwire. Co-investing LPs – if there were any – would have equally born the brunt alongside their GPs.

For investors who followed the fashion because everyone was talking about co-investment, they are going to be faced with a heavy dose of realism and some difficult decisions" – Sam Kay, Travers Smith

Lemonade from lemons
Despite the pain of a liquidity squeeze, the same funding need could also provide fertile ground for co-investors willing to continue in the strategy but open to changing tack.

"We always stress [to our clients] that when you embark on a co-investment programme you should expect to make a series of commitments over time," says Nick Warmingham from global investment firm Cambridge Associates. "If there is a downturn, it is important to look through the cycle because, like PE itself, co-investment is a long-term activity and you should anticipate ups and downs, and unexpected turns of events."

"An interesting development in the market is the opportunity to co-invest at different points in the life of an investment. Typically, an LP comes into a co-investment at the start, but the situation with Covid-19 could accelerate the trend in the increasing number of situations where co-investment opportunities arise at different points in the life of an investment, perhaps to pursue an acquisition or recapitalisation of some description."

In fact, the team at DWS – previously the asset management arm of Deutsche Bank – has carried out six investments dubbed "mid-life co-investments" since it separated from the bank into its own entity in 2018. The difference in strategy is that typical co-investments are carried out on day one of a private equity buyout, head of private equity Mark McDonald told Unquote earlier this year.

As well as those in need, there has been a flurry of private equity sponsors wanting to take advantage of the current situation with opportunistic add-on acquisitions and looking for recaps to fund them. Ardian-owned Italian healthcare software developer Dedalus is one example, launching a debt package at the end of July in order to acquire DXC Technology Healthcare, with others rumoured to be on the lookout, too.

Some companies have done extremely well during the pandemic, with private equity houses wanting to expand in these sectors. Be it new equity, new debt or a recap or add-on, these are all new money needs that co-investment capital could provide.

There is certainly the opportunity for a new set of co-investors to come in, but if an LP comes in mid-way, the investor needs to look at how the GP's existing position is valued and make sure there is protection for all parties. There should be a way to structure the deal so that the alignment is optimised in follow-on rounds, explains Erik Wong, a partner in the co-investment team at asset manager Pantheon.

"The GP universe certainly sees the value that co-investment capital can bring to support their deal execution and portfolio company developments, such as add-ons or transformational M&As," says Wong.

Here to stay
Given that there are still copious amounts of dry powder in co-investment funds, it is unlikely that the strategy will be sidelined despite some hits to portfolio companies. Co-investment is inherently more risky than investing into a diversified pool of assets, but many will still regard the benefits to be sufficiently attractive.

Furthermore, some observers with whom Unquote spoke noted that the appetite for co-invest will not wane at all and there will be investors wanting to double down on robust assets in defensive sectors at this time.

What could also emerge is more appetite for debt co-investment, given that some liquidity needs in recent weeks have been filled by debt. These include KKR-backed Italian vending machine specialist Selecta receiving €50m in fresh financing, while EQT-backed, Switzerland-based visa application provider VFS Global and German transformers producer SGB (backed by One Equity) have both received a cash injection in the form of fresh debt.

Traditionally more popular in the US than in Europe, credit co-investments – which essentially works in the same way as an equity co-investments – have been gaining traction: an LP invests in a direct-lending fund and when that vehicle provides the debt for a private equity buyout, the LP is invited in as a co-investor, bringing down average fees and boosting its own returns.

Says Sam Kay of law firm Travers Smith: "I would expect sophisticated and experienced co-investors will be able to continue their programme throughout the current turmoil and even thrive by having sufficient resources to support portfolio companies (so avoiding dilution) and be able to target high-growth investments. For investors who followed the fashion because everyone was talking about co-investment, they are going to be faced with a heavy dose of realism and some difficult decisions."

And for those troubled assets that are no longer wanted or able to be retained, there is the option of the secondary market, though if there is underperformance in a co-invest an LP would not be keen to sell unless forced.

"There is a growing opportunity here [for co-invest secondaries], as existing investors who have held some of these assets for a decade, or longer in some cases, are willing to exit at a bigger discount," says Gunter Waldner, head of private equity at Tyrus Capital. "However, secondary buyers have to know what they are doing – given the naturally higher concentration and higher risk versus a diversified secondaries portfolio made up of dozens of interests and maybe hundreds of underlying companies, it is vital to understand the asset inside and out. Investors who do not have the resource or capability to analyse the asset bottom up, in detail, are at risk of underwriting too low. For those sophisticated buyers with a strong grasp of the underlying asset, the higher returns profile such deals present versus traditional secondaries portfolios is very attractive."

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