Co-investments demand balance of power – Nick Money-Kyrle

With co-investments now commonplace as LPs increase efforts to avoid fees, it is up to GPs to manage the expectations of their investors while ensuring they themselves are not short-changed.

"For managers of smaller funds, implementing the co-investment wishes of LPs can be quite difficult in practice. It makes their job a lot more complicated and remuneration a lot lower. Were the co-investment process to work smoothly and reliably it would be fine," says Nick Money-Kyrle, managing partner at Steadfast Capital. "It's not that GPs don't want to deliver co-investments to LPs, they're just not positively incentivised to do so and are worried about deliverability."

Similar opinions were reflected in an unquote" straw poll of pan-European mid-market private equity firms. All firms surveyed agreed co-investments largely benefit only LPs. 

Shades of grey
However, there are some positives for GPs. When asked about the benefits, two themes prevailed. The first was the ability to complete larger deals. The second is better management of funds; co-investments can provide extra capital near the end of the investment cycle and prevent being overweight on any one deal.

But co-investments can cause issues for LPs' own fund management, as Money-Kyrle explains: "Co-investments can change the whole balance of an LP's portfolio. Rather than being an asset manager allocating money to funds in a balanced form, some LPs are bringing that out of balance with their co-investment programmes. This is fine until something goes wrong and they realise the underlying investment risk is far higher because it is not spread among a number of investments, in the way that it would have been in a fund-of-funds programme."

While most GPs conceded they would see more co-investments in future, some warned that LP interest could drop off in the next five years "once reality hits". GPs were divided as to whether to offer their better, safer deals to LPs to protect both their investor and their reputation, or whether to offer the bigger, more leveraged deals to limit their own exposure to riskier transactions.

Another advantage of co-investing identified by the GPs contacted by unquote" is the potential to cement the LP/GP relationship by better demonstrating how managers work. Opening up the co-investment to a potential investor may encourage the LP to commit to the next fund.

Favouritism
Herein lies the problem with allocation, or "the hassle factor" as one GP dubbed it. "LP co-investment policies put pressure on GPs to exert favouritism among their LPs. The problem is that every LP has a different approach to co-investments; these vary according to ideal 'bite' size, the stage and depth at which they want to get involved in the deal process and portfolio management, and their willingness or not to underwrite their share of potential broken deal costs," says Money-Kyrle.

Around half of the GPs surveyed outlined the strict process they follow, making all LPs aware of co-investment opportunities and waiting a set period for responses. They acknowledged, however, that this has the potential for complications. "If you are relying on an LP to do a co-investment and that LP says no, then you run the risk of losing the deal and having to bear broken deal costs. This is particularly true where LPs only close a small percentage of the co-investment opportunities offered to them. It's not fair on other fund investors to expect them to bear their share of those costs. As a GP, you need to be fair to all your LPs," says Money-Kyrle.

Equally, offering investments to select LPs who may have something else to offer to the deal is also fraught with difficulty, with one GP describing the allocation policy as the "biggest pitfall" of co-investment deals. He stated that it is "more of an art than a science" and, while offering a co-investment to an LP without expertise in the sector created its own problems, only offering to certain LPs could create paranoia among the remainder.

"As with any aspect of financing a deal, you generally have two or three alternatives lined up, so, if one or two LPs choose not to do the deal or the terms are not acceptable, you have a back-up. From a deal perspective, co-investments make life more complicated for a GP, because they require a lot more work for which one may not be getting paid," explains Money-Kyrle. "Generally, if you're funding everything from your own fund, you know you can deliver the equity and you just have to focus on the debt side. Pre-closing co-investments, like deal-by-deal funding, makes deliverability of the equity less certain and heightens the risks of losing a deal."

While being able to complete deals larger than the fund allows can prove a GP's capabilities, there may be other obstacles. As Money-Kyrle explains: "At Steadfast we haven't done any co-investments recently, although we are very open-minded about them. Recent attempts have been unsuccessful, either because the deal hasn't gone anywhere, the LP hasn't been interested enough or our capacity to deliver equity in excess of the maximum amount the fund could provide on its own was not treated seriously enough by the investment banks. You will always have a competitive disadvantage if your fund isn't big enough to fund the whole deal, especially if your competitors can do the entire deal from their fund."

A free lunch
While the prospect of getting something for nothing is an attractive one, it is the main grievance shared by all private equity firms polled on the drawbacks to co-investing. GPs have questioned the viability of a model which comes "without economics attached". "LPs generally want the GP to focus its efforts on investing the fund that they are invested in and not to be running other business models on the side," says Money-Kyrle. "The move of fund-of-funds businesses towards direct co-investments will ultimately lead to GPs being regarded purely as an outsourced deal generation and negotiation arm for the LP. GPs may feel that this erodes their own business models and ability to run as a stand-alone business."

But it seems LPs only have a certain amount of leverage and it is the established players who can tip the balance of power in their favour. "If your fund is heavily oversubscribed, it is unlikely you'll be open to a co-investment programme that involves you not getting paid any fees or carry. It's all about the balance of power between money on the one side and the direct investment skill-set on the other," says Money-Kyrle.

Time and money
"I know how much appetite is out there for co-investments and I'm convinced I can make it work," says Money-Kyrle. "I'm just saying the approach should be a different one." He suggests two ways to make the co-investment process easier. "LPs might say they're interested but they've got their committees to go to and these may work at a different timescale to that of the GP leading the deal. It is thus better to syndicate post-completion rather than pre-completion as, to be competitive, a GP needs to have a bigger underwriting capability. As long as you canvass your LPs in advance of closing a deal then you should have a fair chance of being able to syndicate a transaction post-closing and therefore to be confident enough to underwrite the co-investment in advance," says Money-Kyrle.

His second solution is to create a dedicated co-investment or "pledge" fund, which he says is "the way forward". Both Isis Equity Partners and Insight Venture Partners have raised co-investment funds of £51.5m and $510m respectively in the last 18 months, which they can use to invest alongside their existing funds. It could also be a chance to reward current LPs, as Isis's Fiona Dane explained when speaking to unquote" last year: "We only engaged with loyal and longstanding backers of Isis's institutional funds to ensure we were structuring a market-standard vehicle."

Although GPs may not feel incentivised to do co-investments for comparatively little gain, it seems the majority are well aware of the current mood among LPs. For the time being at least, compromises will have to be made on both sides to reach that crucial alignment of interest.

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