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Customization Continues to Reinforce GP/LP Relationship

Investors are feeling bullish on co-investment opportunities in private equity over the next 12 months as they look to increase their allocations to this asset class. 


With total dry powder in global private equity and venture capital now standing at a whopping USD1.9 trillion, the onus is going to be on how managers put that capital to work. One consequence of this is that general partners (GPs) will continue to pay high multiples to get deals over the line. Bain & Company’s Global Private Equity Report 2021 shows that the average deal in 2020 was USD 774 million. 

With valuations remaining robust, especially in sectors such as Healthcare and Technology, buyout managers could well look to offer more co-investment opportunities to prosecute larger deals alongside their investors. 

Survey says

In the 2021 SS&C Intralinks LP Survey, co-investing was cited as the most popular allocation route among one in three limited partners (LPs) alongside traditional commingled funds, over the next 12 months. 

David Arcauz, managing partner at Flexstone Partners, expects the co-investment market to continue to grow rapidly in 2021, noting that co-investments are now a regular feature of the relationship between GPs and investors.

“The opportunity set is also widening as investors can consider primary/co-underwriting situations, but also fund existing investments which would require follow-on capital to grow and consolidate a market segment given the current macro-economic environment.

“We expect to keep seeing a steady deal flow of opportunities as this strategy is an important part of the portfolios we build for our clients,” comments Arcauz.

The economic and risk/return benefits of co-investing are well recognized among larger institutions investing in private markets, but the desire to build more customized exposure also extends to hedge fund investors. One of the oldest and most well-established U.S.-based fund of hedge fund managers is Optima Asset Management, which has been building multi-manager and single-manager strategies for three decades. 

“We have some clients who are looking for customization, but we continue to see a lot of interest among investors in commingled funds as well,” says Yehuda Spindler, managing director and head of research at Optima.

“At Optima, we always try to create portfolios that are niche, focused and specialized. Our commingled products are designed to solve for specific market challenges and therefore I wouldn’t categorize them as ‘off-the-shelf’ commoditized solutions. Some of our larger investors have specific risk/return profiles and exposures they are looking to achieve and as a result, we have the flexibility to cater to them as well.” 

One way that Optima approaches customization for its end investors is to get managers to implement a Best Ideas strategy alongside their flagship commingled fund; especially those running sector- or country-specific strategies. 

“Other times we might identify a particular area where an individual manager has excelled and bring it to their attention, with a view to [investing in that area]. In our Long Only hedge fund strategy, we realized that certain managers are excellent at concentrating in their highest conviction ideas, so we created a program that focuses on that high conviction aspect,” states Spindler.  

Sectors to watch

In terms of allocation outlook for 2021, Optima continues to be constructive on the Technology and Healthcare sectors. These two sectors were cited as the most attractive among more than 60 percent of LPs in the 2021 SS&C Intralinks LP Survey

As to how this influences co-investment deal opportunities, Arcauz states that from a sector perspective, the preference is to build a diversified portfolio across all end markets, actively ensuring that its funds are not overly reliant on the outperformance of any particular sector or macro trend.

“Our focus across primary and co-investments is on the small/mid-market on a global basis. We consider that segment to be best suited to generate a stable, attractive performance as the value creation mainly relies on operational growth and improvements. Managers also tend to use less leverage than the mid- to mega-cap segments, which is another protection in times of turmoil.  

“We avoid over-weighting our portfolios towards any specific sector or region per se and prefer working with experienced GPs to get access to their sweet spot as we tend to increasingly back sector specialists,” explains Arcauz.

Alistair Watson, senior investment manager, private equity at Aberdeen Standard Investments, says that co-investing remains a core part of the market. 

“It is helpful in terms of building relationships with managers, working closely with them and having more of a partnership model. That’s really what we are trying to do, working more closely with our managers and seeing them in action, understanding how they are creating value. 

He explains that when making co-investments, Aberdeen Standard Investments will invest through its co-investment funds. “We would then either go directly into the underlying deal structure, or there might be a co-investment vehicle set up specifically by the GP (i.e., a Special Purpose Vehicle) to make things administratively easier.” 

Flexstone has completed over 100 global co-investment transactions since it started to co-invest in 2008. 

“We build dedicated portfolios of co-investments located in specific commingled funds and expect to keep using mainly this type of structure in the near future as it is the best way to avoid potential allocation issues between clients,” confirms Arcauz. 

One interesting question raised in the LP survey was whether LPs would consider paying fees to continue to access co-investment opportunities. Some 35 percent of respondents said they would ‘possibly’ consider it, which is a surprisingly high number. 

Watson, however, does not see this becoming a long-term trend: “I think it’s unlikely. At Aberdeen Standard Investments, we’re trying to build a partnership approach with managers. Co-investing is an important way of building that partnership. I don’t think we will see a major shift towards fee-paying co-investments. 

“The market is working well for both the GPs and LPs so I don’t see any reason why that should change.”

Arcauz expects to see an increase of paying co-investments, as intermediaries and placing agents get involved in raising some of the capital for co-investments, but points out at that Flexstone, “Given our broad network of industry relationships and a deep co-investment pipeline, we see ample opportunities to continue investing without paying fees/carry to underlying lead managers.” 

LPs continue to grow hungry for data

Customization within alternative assets is likely to continue to be an important trend over the coming 12 months as LPs seek to get more data-driven insights on the performance of their portfolios. This is more relevant than ever given the market dislocations that have arisen over the last 12 months as a result of the pandemic. 

But whereas the impact of COVID-19 was very much top of mind among investors in 2020, one of the main concerns for 2021 is the threat of inflation; as evidenced by the recent sell-off in U.S. Treasuries. 

At Optima, they are less concerned about inflation. Of greater concern is how high valuations are in public markets.

“The market isn’t offering a high margin of safety,” says Spindler. “Hedge funds that employ a balanced approach are crucial to navigating market environments where some asset classes are more expensive than others. Investors need to be cognizant of valuations today and take this balanced approach.

“There’s a fragility in the market and a heightened sensitivity among investors using the 60/40 traditional allocation model. Investors are trying to ascertain whether a slice of that allocation pie should move away from fixed income into an alternative allocation. 

“I think this is a paradigm shift for investors, as they look for alternative assets to provide a reasonable rate of return and ballast to a portfolio, similar to the role bonds have played in the past.” 

Meghan McAlpine

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