Direct Equity Investments

The Co-Invest Phenomenon

April 15, 2016
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The past several years have seen an incredible surge in LP interest for co-investments and the GP community, ever ready to heed the LP siren call, has been eager to comply. According to a recent Preqin report1, a total of 72% of the LPs surveyed have co-invested or will consider doing so in the future. Now, we don’t know the details and it can certainly be debated whether these figures represent LPs that have only ever done a single co-investment in the life of their private equity portfolio OR those LPs who are building out and running an active co-investment program. Whatever the case, this “co-invest phenomenon,” as one of our GPs has so aptly labeled it, doesn’t seem to be showing signs of abating.

On the other side of the table, the same Preqin survey reported that 69% of GPs surveyed currently offer co-investment rights, and a further 18% are considering doing so in the future. So, the question becomes, will this trend prove to be a good thing or a bad thing for the industry? From our perspective, there seems to be a heck of a lot more talk about a desire to co-invest than there is any actual co-investment done by LPs. As such, when it comes to the current “co-invest phenomenon,” we believe that many of these programs will ultimately lead to frustration and disappointment – for LPs and GPs alike. 

Background

Co-investing isn’t new; it just seems like it is. Hamilton Lane has been co-investing for more than 20 years, and it is a significant part of our business today with $2.8 billion of AUM2. Taking into consideration industrywide data that exists, as well as our own experience, we have long believed that an allocation to co-investments can enhance returns and provide diversification to an LP’s private equity portfolio. Then why the current pessimistic view? As with many things in life, it really boils down to a matter of expectations vs. reality. 

LP Perspective

Let’s take a look at what is driving LP appetite for co-investments. LPs are interested in co-investing on the basis that it will improve returns through lower overall costs, create faster and more targeted deployment of capital, and allow them to have fewer overall relationships. It also doesn’t hurt that co-investing is sexier to talk about at cocktail parties. With the exception of the last factor, LP interest in co-investment is based on solid rationale; co-investing can be effective in each of these areas. 

GP Perspective

Co-investments offer unique benefits to GPs as well. Co-investing allows GPs to manage fund exposures, expand the size of their target investment universe, avoid partnering with other GPs (ask any fund manager to describe an experience in “club” deals with other GPs – chances are, you won’t get a terribly positive response), and build closer relationships with key investors.

Occasionally, the motivation includes incremental economics. Leaving aside the moral outrage between GPs and LPs on the topic of fees on co-investments, co-investment between the two camps sets up nicely to be a win-win. 

Tipping Point

The following analysis originally appeared in our latest Market Overview as part of a broader discussion on capital raised outside of traditional fund structures (Chart 1). This capital represents separate accounts awarded to GPs, as well as co-investment capital invested in transactions. We’ve dubbed the combination “shadow fundraising,” as it is capital not officially captured in fundraising statistics.

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Although there are broader possible ramifications regarding shadow fundraising, for this discussion, we will focus on the implications for co-investment. For much of the industry’s history, co-investment existed as a small part of the overall private equity market. The notable exception was 2007, which was driven by the rise of mega deals requiring massive amounts of equity capital, combined with LPs eager to increase private equity allocations and new entrants to co-investing in the form of hedge funds and investment banks. Needless to say, that era of co-investment boom ended poorly for both investors and fund managers; the 2007 and 2008 deals have been the worst-performing vintages since the Dot-com bubble burst in 2000 (Chart 2).

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Following the onset of the financial crisis, overall private equity fundraising declined precipitously. Faced with this challenging environment, GPs were looking for opportunities to raise new funds and to develop closer relationships with their LPs. At the same time, many LPs - particularly those newer to the asset class - were eager to ramp up their private equity allocations. Moreover, these investors recognized that the negotiating pendulum had swung back in their favor, and thus LPs had the opening to ask for something in exchange for their fund capital. Allowing for hyperbole, the conversations went something like this: 

LP – “We will commit to your fund, but we expect that co-investment opportunities will be made available to us.” 

GP – “OK.” 

As a result of such interchanges, GPs now gleaned another benefit from co-investment, coupled with a strong incentive to offer it since doing so was widely perceived to improve the chances of a successful fundraise. That GP perception proved accurate; co-investment rights quickly came to be seen as a requirement, particularly from larger, more sophisticated LPs, who were in a position to make or break GP fundraising. Thus, the co-investment phenomenon was born.

What Could Go Wrong? 

Unfortunately, we believe that many GPs and LPs alike were unprepared to handle a surge in co-investment. GPs didn’t fully appreciate how much time and energy it would take to manage co-investment processes, particularly when partnering with LPs who hadn’t co-invested in the past. The delays and uncertainty that can be introduced into transaction timelines, which are usually tight and competitive, proved challenging. We’ve heard more horror stories from GPs about bad co-investment experiences over the past twelve months than we’ve heard in the prior five years combined. At the same time, the SEC is increasing scrutiny on co-investment allocation policies, risk-sharing on broken deals, expense-sharing, as well as syndication processes and timelines. These dynamics mean more work, more headaches, and more scrutiny for GPs. And, for the most part, there is no new revenue associated with these co-investment activities. 

For many LPs, the new order of co-investment has also proven to be a challenge. Not all LPs fully appreciate the resources or expertise required to execute co-investments well, or to monitor them for that matter. Those requirements include investment professionals capable of evaluating the investments, decision timelines that are a matter of just weeks rather than months, legal resources to review and execute transaction documents, and ongoing portfolio monitoring and reporting. To deliver on these requirements, LPs must make an investment in building out these resources, and that can be a costly and time-consuming proposition. The common GP refrain is that, even among LPs that regularly ask to see co-investment, very few LPs actually participate because of these constraints. Remember the GP/LP conversation that occurred during fundraising? Too often, the next conversation goes something like this: 

GP – “We are pleased to reach out to you with an interesting co-investment opportunity. Our deal team is available to speak with you about the deal as soon as possible. We are seeking co-investor commitments by date XYZ.” 

LP – “Sounds interesting. How much flexibility is there on the timeline you described? We are very busy, and will have to decline if there is no flexibility in the timeline. Please call us on the next opportunity.”

This type of exchange occurs much more frequently than one might expect, particularly given the purported LP interest in co-investing. In fact, the same Preqin survey reports that 40% of GPs stated that none of the LPs to whom they offered co-investment opportunities in the first half of 2015 actually invested. That’s a staggering figure considering the amount of time and energy spent by both parties discussing and evaluating co-investment. 

For those limited number of LPs that are actively co-investing and building out an actual portfolio, access to significant amounts of diverse, high-quality deal flow is critical. By point of reference, Hamilton Lane reviewed more than $8.0 billion in co-investment opportunities in 2015; yet we invested in less than 10%. GPs would like to keep all of their LPs happy, but they face their own constraints and often prioritize co-investors based on the importance of the relationship and the LP’s ability to execute.

For many LPs, the new order of co-investment has proven to be a challenge.

LPs without sufficient high-quality deal flow to satisfy their deployment targets may resort to investing in lower-quality deals, or alongside lesser managers. One of the challenges of the current environment is that the top-tier GPs are not the only ones that have recognized the allure of offering co-investment. In fact, for GPs that are having trouble fundraising, co-investment is one of the first things they offer to prospective LPs to build new relationships. In some cases, GPs may request stapled fund commitments in exchange for allowing an LP to co-invest in a specific deal, or economics on co-investment as an alternative way to generate revenue. For less experienced co-investors, these can be tricky dynamics to navigate.

Perhaps our greatest concern is that not every LP has adequately considered the full implications of adding co-investment to their portfolio. Chart 3 illustrates some of the good and the bad when it comes to co-investment performance.

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You can see that co-investment has the highest top-quartile returns of any investment strategy for the time period. Co-investors everywhere, rejoice! However, you’ll also notice that the dispersion of returns is huge. For co-investment to be additive to portfolios, it needs to be done well, and even then investors should expect a much broader range of outcomes in individual deals than in their funds. Our data on individual deal performance shows that an average of 20% of private equity deals lose some amount of capital, and those individual deals have the power to create tremendous volatility in LP portfolios (Chart 4). 

Further, co-investments can shift portfolio exposures, and LPs should expect that individual deals will become significant contributors or detractors from overall program performance. When our research team performs track record attribution analyses for programs with co-investment, individual co-investment deals frequently show up among the top positive and negative contributors to performance. Some LPs understand this dynamic, and are set up to withstand it. Unfortunately, for some other LPs, poor performance in an early co-investment can place their co-investment program in jeopardy, and subject their entire investment plan to internal and external scrutiny and negative publicity. We have witnessed this dynamic play out time and again. Those situations generally don’t work out well from the GP’s perspective either.

View transcript here
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Outlook 

Without a crystal ball, it’s impossible to know exactly how co-investment dynamics will change in the coming years. In the past, LP interest in co-investment has proven to be cyclical, with many LPs halting investment activity following periods of poor performance or downturns in the market. Conversely, top-performing GPs may become less willing or more selective in providing co-investment opportunities given the challenges they’ve faced during this past cycle, a desire to deploy fund capital, or a fundraising environment that has shifted back in their favor. In a world where not all co-investors are created equal in terms of access, resources and thoughtful portfolio construction, we fear that many co-invest programs are on track to ultimately disappoint.


ENDNOTES
1 Preqin’s Private Equity Co-Investment Outlook, November 2015
2 As of December 31, 2015

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