Co-Investing is Not For Tourists
As investors embrace private market investments, the desire to build closer, more meaningful relationships with a network of trusted GPs continues to grow. Within private equity, especially, one way to deepen those relationships has been for LPs to actively seek out co-investment opportunities.
28 May 2020
In the recent global LP survey produced by SS&C Intralinks in partnership with Private Equity Wire, 30 percent of investors said that throughout 2020 co-investing would be their preferred investment method, alongside commingled fund investing. What is perhaps even more surprising is that 34 percent cited direct investing.
Twelve months ago, when the markets were still riding high and private equity was continuing to attract significant capital inflows, it was easy to appreciate why investors would want to use co-investment deals as a way to further bolster their GP relationships.
As Rhonda Ryan, head of European private equity at Mercer, one of the world’s leading investment consultants with USD 304 billion in delegated AUM and USD 15 trillion in assets under advisement, comments: “Investors like co-investing. Many think it’s more exciting than fund investing, but you can’t enjoy it if you’re not delivering returns to your board of trustees. Just thinking it is more exciting is not a justification for co-investing. And if you get it wrong, it could leave a meaningful gap in your portfolio.”
In the current market environment, COVID-19 has had a deleterious effect on the global economy with recessionary fears now very much front and center of people’s minds. Would co-investing and direct investing figure quite so highly, were the survey to be conducted today? Arguably not, as investors start to realize the negative aspects of getting more closely involved with companies and figuring out whether they can make payroll that month, or not.
“The reality of being a direct investor is very likely to be hitting a lot of what I would refer to as ‘co-investment tourists’ right now, in a big way,” says Elias Korosis, partner at Hermes GPE & portfolio manager, Hermes GPE Environmental Innovation Fund.
It is fine being a co-investor when things are fine and dandy, and everything is going well. However, if things go badly and the GP has to structure follow-on rounds and agree them with investors, and those investors find they are being asked to offer leadership, then it becomes a very different proposition.
“I think there could be some resurgence in segregated managed accounts among large investors who might previously have considered direct investment vehicles because of what has happened to valuations in private markets,” adds Korosis.
In the survey, 60 percent of LPs who cited direct investing as a preference said that their area of focus would be on the private equity middle-market. This would now appear highly risky in the current environment, given that some companies are going to need a lot of hands-on operational support.
“Direct investing introduces an even higher level of risk than co-investing,” says Ryan. “The question mark around this is that LPs are competing with their GPs – but can they afford to hire the best talent, and compensate them? Investors can compete for deals on price, but do they have the skill set to work with companies through a recessionary period? It requires large, sophisticated operational teams. Do LPs have the bandwidth? I doubt it.”
Importance of strategic vision
Korosis adds that investors should have a strategic commitment and the right institutional set-up “to be able to act in a direct way.”
“Co-investing is a big part of our investment activity and where we generate the outperformance. We've done quite a significant amount of co-invest deals in PE buyouts — think of these as our crown jewels — and we'’'ve also done some direct investments in infrastructure, as well as more recently on the growth equity side.
“You need to have a clear strategic vision. Weve implemented our co-investment program systematically and we have a team of 25 investment professionals who spend the majority of their time focusing on the co-investment engine. That makes us comfortable dealing with the ups and downs. I firmly believe once trustees see losses materializing, particularly if investors have not built diversified portfolios (we have 30 to 50 positions in our flagship co-investment fund), there are going to be a lot of question marks.”
Co-investing is not an allocation strategy that investors can do in a half-baked way. Swayed by a herd mentality, investors have doubled down their efforts to commit additional capital to co-invest deals, in large part because they believe the economic benefits are too good to pass up.
Indeed, the potential for increased returns was given as the main driver behind LPs co-investing in the LP survey.
But if an LP has only got eight or nine co-investments, and two of them go south, it''s going to be difficult to make that co-investment program work.
“The P&L is going to look unfavorable and be underperforming compared to the commingled fund. Then trustees will start to ask whether such a co-investment program is really adding any value. If that happens, then you get stuck with an undiversified portfolio.
“Doing two or three co-invests a year, over a few years, with a small team … I think right now, that would be an uncomfortable place to be,” suggests Korosis.
Economic gains still attract LPs to co-investing
The next few years are likely to be the best time for co-investing, now that asset valuations in sectors such as consumer retail and energy are lower. At Hermes GPE, they are gearing up to invest in the right themes in a post-crisis period, and be active investors. This is now not a time to be sitting on the sidelines – which might well be the case if LPs have not been strategically committed to building diversified co-investment portfolios.
“If you get caught in internal politics because you didn’t have a strategic commitment, the overall result is you would have ended up investing in a higher market, only to then take a pause right at the time when valuations are much more attractive. This is the classic risk of doing things in a half-baked way,” remarks Korosis.
“The negative aspects of not having adequate portfolio diversification will easily far outstrip any fee savings an LP might achieve. If you want to go into co-investing, don’t simply do so for fee savings. If you don’t have the right systems and processes in place, you won’t be able to source co-investment deals far and wide.”
At Mercer, Ryan’s main concern would be whether investors understand the level of risk they are introducing to their portfolios. How many co-investments are they doing? Are they one-offs?
“You need a diversified portfolio to generate superior returns in private markets. I wonder if some investors will come away with burnt fingers as a result of the recent market downturn. If one large co-investment becomes a write-off, it is going to wipe out any of those economic gains the investor thought they were getting,” says Ryan.
She believes co-invest deal flow might well contract in 2020.
“I spoke to one of my co-investment colleagues in the U.S. recently and he is expecting deal flow to come down this year. GPs are doing fewer transactions, meaning there are going to be fewer co-investment opportunities to offer investors.”
If an LPs strategic objective is to reduce fees, they are likely to be attracted to bigger deals where they can put more capital to work. The problem with this is they might end up with a large-deal bias in the portfolio and larger deals tend to be the most pro-cyclical in the market.
When the market cycle turns, as it has this year, that is going to hurt LPs by orders of magnitude more than the original fee-saving.
Korosis’ advice to investors is they need to have the right co-investment exposure through the market and the right thematic deal sourcing capability. This, he says, gives investors the ability to at least map co-investments correctly to their target investment strategy, rather than be limited by the deals being offered.
“Implementing our target strategy is the main reason why we use co-investing to achieve our desired investment outcome,” confirms Korosis. “There is also a relationship risk to co-investing with a GP if you’re not able to meet their timelines or their way of operating. You have to be a very responsible partner.”
It will certainly be interesting to see how LPs view their allocation preferences for the next coming 12 months, if, as is likely, some of their portfolio investments have incurred significant write-downs.
This environment is sure to test the level of LP commitment to co-investing.