LP co-investment: Finding the balance

Hermes GPE was the talk of the unquote" Private Equity Summit after it revealed it allocates half its assets under management to co-investment programs. As its LP peers, such as HarbourVest and Capital Dynamics, have a mere 5-10% in their equivalent pots, Hermes GPE's strategy has caused some LPs to balk at the thought. "Their entire fund could be wiped out with just one or two bad deals," said one.

A better way to play the co-investment game is on a highly selective basis, believes HarbourVest's Claudio Siniscalco, who rejects up to 19 in every 20 opportunities he sees. "If as much as 50% of your AUM are in co-investments, you're being less selective by definition," he says. He also points out that GPs value customers in their blind pool funds first and foremost, so co-investors can end up unbalancing things if they keep most of their capital outside of the traditional GP-LP arrangement. "At the end of the day it can lead to a less healthy relationship between the two parties."

Hermes GPE however maintains that having a large co-investment allocation has generated value for the firm. "We've had really strong returns and our clients like us doing it, so we have no reason to reduce it," insists head of Europe Simon Moss. "The portfolio is actually one of our best performing." The firm claims that it stays selective by having flexibility in the composition of its investments. So if it gets to the end of the year and finds it's only invested 20% because of a lack of deal opportunities, it can either increase its allocation to funds or simply invest less that year. "What determines whether we do up to 50% is the quality of the deals getting done."

I want to hold your hand
But how did firms like Hermes GPE and HarbourVest (which has a 21-strong dedicated team) come to embrace co-investment in the first place? According to Moss, ten years ago it was all about dodging fees and carry for Hermes GPE. "The LP base was very diffuse so it was impossible to arrange a coordinated effort to put pressure on fees," he says. "We completely failed in our negotiations with GPs and found this was an effective way of getting what we wanted." Other advantages which became apparent over the past decade include "imposing [Hermes GPE's] strategic world view" on investments in a way that isn't possible as an LP, and having more control over the timing of capital injections. Siniscalco adds: "Having a healthy relationship with a co-investor is just another way for GPs and LPs to work together in a trusting fashion and it's typically win-win from both sides. The GP gets more exposure to the LP and has a happier customer, and the LP gets to know the GP much better outside of the scope of a marketing process."

In spite of the benefits, the truth is that most GPs would usually prefer to have a co-investor's cash in their own vehicle to do what they like with. "They would definitely prefer that," concedes Moss. Nevertheless, Siniscalco points out that there are times when GPs (typically smaller funds and country funds) need co-investors in order to carry out larger deals. "In certain geographies such as Benelux or Italy, anything over €1bn would be an incredibly large fund to invest locally," he says. "As a result, a deal may come along for which the fund doesn't have enough fire power. Having co-investors ready and willing could therefore be a very positive thing." Other GPs might be drawn to co-investors due to issues of control - a co-investor is likely to be more passive and rarely gets a full seat on the board, allowing the direct investor to call more of the shots.

The right time for co-investment appears to be now, with the likes of Hermes GPE and HarbourVest claiming they see a surplus of opportunities in the market. It's reasonable to assume, however, that once fundraising returns to more normal levels, enthusiasm for the practice could begin to wane. Moss is adamant that his head won't be turned unduly if an influx of new vehicles floods in, and that the only thing which could lead Hermes GPE to co-invest less is a "really slow deal environment", which is itself likely to lead to a slow fundraising landscape. A bigger impact will be felt if other LPs decide to adopt co-investment in their droves, though, as Moss worries: "If a lot of LPs take it up because they recognise the benefits, there'll be even greater competition as there'd be less deals to go around."

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