Benefits and Challenges of Co-Investments for Private Equity LPs

Amid rising debt financing costs, constrained liquidity, and fundraising challenges, private equity GPs are turning to co-investment capital to fund larger equity contributions and foster deeper relationships with LPs. As a result, co-investment deal flow and activity have remained steady despite challenges in the broader buyout and venture landscape since 2022. Concurrently, LPs have increasingly flocked to these opportunities over the years, largely drawn to enhanced return profiles and lower fees.

Further, as a decade of ZIRP comes to a close, private equity returns are under many allocators’ microscopes. Cognizant of the challenges higher debt costs will bring to value creation efforts and ultimate returns, LPs’ appetite for co-investments will only grow. Management fees and carried interest payments significantly eat into net returns, and more allocators will likely look for opportunities to invest directly in portfolio companies outside of traditional fund structures.

However, while co-investments offer LPs a laundry list of benefits, they also present notable challenges, and different entry points into co-investments offer varying benefits and risk profiles. Co-underwriting alongside GPs requires a very different skill set and data management needs than committing to a fund of funds with a robust co-investment strategy. Here, we explore the top considerations for LPs exploring co-investment opportunities.

What Makes Co-Investment Return Profiles Attractive?

Several characteristics of co-investments make these opportunities great return enhancers. In typical private equity funds, managers may pay several years’ worth of management fees before meaningful capital is deployed. Since most co-investments tend to have no fees and reduced or no carry, they minimize or eliminate the drag on undeployed capital, muting the J-Ccurve effect associated with traditional fund investing.

Further, lower fees tend to directly affect the overall profitability of co-investments. Academic research indicates that, on a net basis, considering all common fee structures and costs to run co-investment programs, buyout co-investments meaningfully outperform their corresponding funds. Multi-manager co-investment funds have also been shown to outperform traditional buyout funds, driven by their lower overall costs. These funds typically charge a 1% annual management fee on committed capital and take 10% of net gains as a performance fee — about half of what a typical buyout sponsor charges. As a result, gross-to-net yield erosion is notably reduced, especially in higher-performing funds.

Many industry-leading allocators have corroborated these findings. Chris Ailman, the former CIO of CalSTRS, noted that while private equity fund commitments yielded a five-year IRR of 18.9%, co-investments achieved a striking 27.1% IRR in the same period, saving over $780 million since 2017. Tamara Polewik, a director of the co-investment program at the Teacher Retirement System of Texas, has similarly highlighted the outperformance of the pension’s co-investment portfolio, which increased its allocation from 25% to 35% over the past couple of years. These sentiments are overwhelmingly shared amongst allocators, with 80% citing observed outperformance in co-investment strategies.

“Our co-investments have absolutely outperformed our regular funds. The deals we have been seeing have outperformed the funds themselves.”

Tamara Polewik, Co-investment Director, The Teacher Retirement System of Texas

How Returns Vary Depending on Strategy, Fee Structure, and the Economy

It’s important to note that co-investment return profiles will vary depending on an LP’s approach to co-investing, the investment’s underlying strategy, fee structures, and economic conditions. Unsurprisingly, fee and carry structures and economic cycles are inherently linked to returns. Structures with lower fees and carry tend to generate more attractive return profiles, and investments made in the wake of economic troughs are more likely to outperform.

Additionally, the high dispersion and skewed nature of deal-level returns demonstrate that investors building co-investment strategies must construct diversified portfolios to ensure they protect against any underperforming investments and have the best chance of gaining exposure to massive outperformers. This is even more pronounced in venture co-investing, which exhibits broader return dispersion compared to buyouts and has been shown to only achieve outperformance on a no-fee, no-carry basis — an important distinction given that they are more likely than buyouts to include fees.

Visibility Into A GP’s Investment Process

Co-investing gives LPs a front-row seat to a GP’s due diligence and post-investment processes. This unique vantage point into the inner workings of deals helps LPs gain visibility into how sponsors assess, structure, manage, and drive value in their investments. By working side by side with fund managers throughout an investment’s lifecycle, LPs can hone their own investment skills and sector expertise.

This, in turn, fuels better vetting of fund managers, understanding of different sectors, and assessment of return or value creation drivers. For many institutions with their eyes set on developing direct investing programs, this enhanced participation offers a natural stepping stone in that trajectory.

Further, working closely with GPs on co-investments can strengthen and deepen investor relationships. This can prove particularly valuable for LPs looking to ensure access to high-caliber GPs whose funds may become oversubscribed and where investor participation in the main fund is rationed.

Flexible Portfolio Construction

In traditional fund investing, LPs seek out sponsors whose investment thesis aligns with their desired return profiles, and GPs, as experts, are trusted to source and execute the best deals. This model has many advantages, but limits LP’s ultimate control of how their portfolio construction manifests.

Co-investments provide a flexible tool for LPs looking to employ a more active role in their private equity portfolios. Allocators can use co-investments to make bullish bets, compound exposures in certain sectors or geographies where they have high conviction, or capitalize on short-term tailwinds. The same can be said for vintage diversification. If LPs want access to certain vintages outside their active fund’s investment periods, co-investments offer a great avenue for that exposure.

Investors can also tap co-investments to better align investment pacing with their cash flow needs. In contrast, commingled funds require forecasting the timing of contributions and distributions to ensure adequate cash on hand for capital calls, assessing cash flows against liability obligations, and mapping future commitments.

How Co-Investments Can Challenge LP Portfolios and Operations

While co-investments significantly benefit private equity portfolios, they pose notable risks and demand robust operational resources. Thorough due diligence, intentional exposure management, and post-investment monitoring are crucial. Technology can play a key role here, offering the much-needed infrastructure for LPs to better navigate and mitigate these challenges.

With Conviction Comes Concentration

GPs who bring co-investment opportunities to LPs often do so because the deal’s transaction sizes will place them outside their main fund’s concentration and diversification limits. Thus, as a result, LPs accumulate both a direct stake in the company alongside additional exposure through the corresponding fund position, compounding concentration in underlying companies within co-investment strategies.

 

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In growth and venture, concentration becomes even trickier to manage. As venture-backed companies stay private for longer, LPs may get offered co-investment participation in a company they already have earlier exposure to via a different manager(s). Further, beyond companies themselves, co-investments can also compound exposures in geographies and sectors, depending on an LP’s deal flow.

Ultimately, as LPs acquire many minority positions across their co-investment allocation, the valuations of the underlying companies become more important to monitor. In a diversified commingled fund, high-performing assets can offset valuation declines in other companies. Co-investment portfolios are not afforded the same luxury. Composed of a smaller pool of companies, valuations are more volatile, creating more upside and downside risk.

In-House Co-Investment Programs Consume Significant Internal Resources

Co-investing and direct investing is not fund investing. Industry expertise and operating knowledge are crucial to properly source, underwrite, and monitor attractive opportunities. Bringing investment professionals in-house to run a co-investment and direct program means competing with the wallets of private equity firms, and LPs have to consider whether they can hire staff with commensurate compensation and performance incentives – an interesting human consideration for public-serving institutions like pension plans.

Additionally, LPs who participate in co-underwriting opportunities need to weigh the implications of more active participation. In these scenarios, LPs must become more involved in strategic direction and operations. Sometimes, LPs even take on active governance roles via board seats, sitting on committees, etc.

Even in more passive co-investments, minority positions still require more active monitoring than fund investing. Co-investors must perform quarterly valuations, review quarterly financial statements and board presentations, and anticipate any future needs for follow-on investments, among many other considerations.

Further, effective co-investment monitoring and sourcing have become more significant against the current macro backdrop. In a higher interest rate environment, LPs must identify high-quality assets in resilient markets with strong margins and cash conversion metrics that will confidently sustain the cash flow and growth trajectory required to outperform.

Approving Transactions Under Tight Timelines

These resource challenges are compounded by compressed timelines for approving transactions and the unpredictability of deal flow. Once a GP opts to pursue an investment, co-investors have a brief window — ranging from a month to as little as two weeks — to assess the opportunity, decide on participation, and secure internal approval. A big part of the allure of co-investments for sponsors is minimizing execution risk. Backing out at the last minute or being unreliable can quickly strain LP-GP relations.

Ultimately, investors must think tactfully about whether they have the skills, expertise, and budget to manage a resource-intensive co-investment and direct program in-house or whether they’re better off gaining similar exposures via another route.

Adverse Selection

Co-investing allows allocators to try their hand at being GPs; based on their own analysis, they select companies they think will outperform and compound exposure. This makes deal selection and due diligence critical. Evaluating a company’s fit with a manager’s stated investment thesis, typical deal size, and skill set proves paramount to identifying winning opportunities.

A Cambridge Associates analysis found that co-investments within a GP’s ‘strike zone’ (targeted sector, geography, etc.) delivered a 1.65x MOIC, while deals outside of the strike zone tracked only slightly above cost, at 1.02x. Further, more than 20% of deals within the strike zone exhibited a MOIC above 2.00x, compared with only 7% of the non-strike zone transactions. Similar results were found looking at deals within and outside of the sponsor’s targeted enterprise value. In short, co-investing within a GP’s area of expertise is paramount.

How Chronograph Helps LPs Streamline Their Co-Investment Programs

Ultimately, co-investing is a more resource-intensive private equity strategy than traditional fund investing, and as LPs look to gain access to these opportunities, there are several ways Chronograph can help streamline the operational challenges:

  • Look Through Analysis: With Chronograph, LPs can seamlessly view their company exposures and total unrealized value across various fund positions (such as co-investment structures and the corresponding fund vehicle). As a result, they can gain deeper visibility into their co-investment exposures and better manage risk.
  • Aggregate Exposures: Further, as LPs evaluate opportunities, Chronograph provides real-time visibility into existing portfolio exposures, helping LPs streamline deal assessments by illuminating whether they are under or over-exposed in the potential company’s sector, geography, and currency.
  • Analytics: Additionally, with all data on prior commitments and corresponding performance centralized, LPs can easily compare how potential co-investment opportunities align with a manager’s past performance, typical enterprise values, etc.
  • Streamlined Data Collection: Co-investors can also use Chronograph to toggle the line between LP and GP by automating data collection and quarterly valuations for the underlying companies in their co-investments. Additionally, with data centralized, they gain greater visibility and granularity into company performance.

Request a demo to learn how allocators leverage Chronograph to understand the performance of underlying companies in co-investment strategies, aggregate exposures, conduct valuations, and more.

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