Co-investments have been an interesting and positive feature of private equity investing for a long time. However, in times of abundant money, there is also an abundance of co-investments and on average they are much less interesting.

Co-investments were invented to give private equity fund managers some flexibility when a very good investment was identified, which requires a little more money than the rules of their fund allow. Buyout funds typically limit individual deals to 15% of the total fund. In exchange, supportive fund investors get a sweetheart deal on their co-investment fees i.e. none.

The number of co-investment deals worldwide has risen from 100 in 2009 to a shade under 600 last year, according to CEPRESS. In 2009, co-investment funds accounted for 9% of the total capital raised by fund-of-funds. In 2016, 32% of fund-of-funds capital was dedicated to co-investment funds.

Co-investments in boom times underperform

Carefully selected co-investments boost returns, but careful selection is not the norm in today’s market. A study of direct investments by seven large investors in private equity funds from 1994 to 2011 was done by Josh Lerner, Lily Fang and Victoria Ivashina of Harvard Business School. The authors found that mean returns were 8% lower than returns from the same funds[1].

Below is a summary of the main conclusions,

Co-investments underperform the investments of the corresponding funds with which they co-invest

This underperformance appears to be driven by selection (a “lemons problem”): institutional investors can only co-invest in deals that are available to them

Transactions are substantially larger than an average sponsor’s deal and appear to be concentrated at times when ex post performance is relatively poor

According to this study, investments performed better in the 1990s than the 2000s, while co-investment underperformance was at its peak in 1997, 2004 and 2008, years when private equity investment was at record levels when market conditions were like they are today. Lerner’s findings should not surprise us.

If there is much money in private equity, like in the current environment, co-investments are mainly used to do much bigger deals (see graph below). Bigger deals for fund managers are better,

as they get more fees and hopefully prove that they can do bigger deals and thus raise bigger funds. This is an expensive way to test managers and may not be in the interest of fund investors.

If there is a shortage of funding, prices are down and co-investors have much more leverage. Being countercyclical also has merits in private equity and is amplified in co-investments.

Co-investments have a place in a carefully constructed private equity portfolio, if interests are aligned and if private equity managers invest in the “sweet spot”, where they have been successful in the past. Such managers typically have invested profitably in the same industry before and are in their comfort zone when it comes to the size of the transaction. In the current market, investors should be especially careful, as co-investments have grown exponentially. In our view this is not a long term trend but getting close to the peak of a cycle.

 

[1] Fang, Lily, Victoria Ivashina, and Josh Lerner. "The Disintermediation of Financial Markets: Direct Investing in Private Equity." Journal of Financial Economics 116, no. 1 (April 2015): 160–178.

https://www.hbs.edu/faculty/Pages/item.aspx?num=47928

 

 

 

Hans van Swaay
Partner
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