Co-investments – a process whereby allocators participate alongside their private equity managers in deals – have become very popular, but concerns are growing about some of these set-ups.
The increased client appetite for co-investing is unquestionable with a report by data provider Preqin, stating 42% of limited partners (LPs) were currently co-investing in deals, while 12% acknowledged they would consider it.
Equally, a study by Vistra found 73% of investors welcomed the growth in co-investments that has taken place over the preceding five years. Managers have on-boarded these not so unsubtle hints from clients. In this highly competitive environment for LP money, managers have little option but to offer co-investment opportunities if they are to stand any chance of raising capital. As a result, the same survey by Preqin found 58% of managers now provided co-investment opportunities to end customers.
By allocating money in conjunction with their private equity managers, investors often get discounted fees. Speaking at the ALFI Private Equity and Real Estate (PERE) Conference in Luxembourg, Jerome Wittamer, president of the Luxembourg Private Equity & Venture Capital Association (LPEA) and founding partner at Expon Capital, said management fees on co-investment deals were typically priced at 1% versus the 2% private equity standard, while performance fees were around 10% compared to the traditional 20%.
The fee benefits are not the whole story. The chief advantage of co-investing is that the returns tend to be better. “The return benefits of co-investing are significant as the transactions tend to be the prime deals. This is evidenced by the fact that co-investments frequently outperform fund performance,” said Wittamer. The caveat of course is that investors have far greater concentration risk to the investments so while the rewards can be more generous, the risks tend to be much higher.
Wittamer added co-investing provided more capital for managers to work with on deals, although highlighted that most transactions tended to small-to-medium sized. He pointed out many of the large buy-outs by large private equity managers generally did not require any of the additional funds that could be unlocked through offering co-investments.
Nonetheless, co-investing brings about a number of corporate governance challenges and operational issues for the industry. “Co-investing can occasionally be a distraction for managers as the process takes more time, and this can sometimes endanger deals. This may be because some LPs do not always understand the way in which certain deals are structured,” said Wittamer.
Other panellists said co-investing often created problems around the allocation of fees and costs. A briefing by law firm MJ Hudson warned that managers must be consistent in how they apply expenses and charges to clients. “The GP (general partner) should have allocation policies and procedures in place and apply them consistently to ensure that all LPs, whether co-investing or not, do not pay more than their fair share of expenses in the context of any co-investment, actual or aborted,” said the MJ Hudson document.
The MJ Hudson article also warned LPs that identifying companies to buy and sell was a very different proposition to acquiring units in private equity funds. A lack of LP understanding about co-investing therefore exposes clients to heightened risk and losses should deals go wrong. “Some LPs such as state-run pension funds may face constraints on how much they can pay staff which makes it difficult to recruit top quality talent from investment banks and major private equity firms,” added the MJ Hudson report. Nonetheless, it highlighted that co-investors lacking an experienced team could leverage external experts to assist them with due diligence and transaction management.
A growing trend, according to Frédérique Lifrange, partner at law firm Elvinger Hoss Prussen, has seen an insistence by LPs demanding that not every client receive the right to co-invest on deals. “Some LPs have been negotiating with their managers to impose a minimum investment threshold before they are allowed to co-invest. There is a fear that some investors are allocating small tickets purely so they can co-invest at a later stage,” she said.
Co-investing is not the only challenge facing the private equity industry. Some of the biggest institutional investors – including major pension funds, sovereign wealth funds (SWFs) and insurance companies – have started to invest directly into transactions, in effect disintermediating private equity managers from the deal-making process. For example, the Ontario Municipal Employees Retirement System (OMERS), which looks after $60 billion, created its own private equity team, as the institution sought to expand its direct investment capabilities.
Again, there is speculation that some of the major investors may dial down their private equity exposures if the economics of building an internal team makes more sense. As with co-investments, having a more concentrated exposure to deals does introduce additional risks which may be unacceptable for some beneficial owners to tolerate. Ultimately, many investors will retain private equity exposures in addition to co-investing or direct investing for diversification and risk-mitigation purposes.