This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.
Author: Kevin Lu, Senior Fellow, Milken Institute, Akanksha Madan, Research Student, Yale-NUS
- Co-investment is a financial model that allows small investors to collaborate with larger partners, avoiding fees, exchanging knowledge and opening up new investments.
- In 2012, 24% of sponsors used co-investment. In 2021, this figure was 71%.
- Top investors have shared their tips on how best to approach closing a co-investment deal.
Co-investing as a strategy has been on the rise for years.
A trend documented by the World Economic Forumco-investment as a model sees limited partners (LP) take a direct stake, or “co-invest”, in a particular asset with their general partner (GP) – often a larger institutional investor – in addition to their investment in GP funds.
Over the past decade, co-investing as a strategy has taken the world of private equity funding by storm. In 2012, 24% of sponsors used co-investment in their portfolios. In 2021, this figure was 71%. Co-investment is becoming a must for investors around the world.
Co-investing has often been seen as an LP-led exercise used to reduce overall private equity investment costs – that’s not wrong, but that’s not all.
Research shows that LPs are driven by more nuanced factors. For example, beyond more essential reasons such as risk management and increased allocation to alternatives, research indicates that GPs seek knowledge exchange with their GPs. In fact, the primary motivation for some LPs to co-invest is to work with their top managers and learn from their top managers about industries, trends, and best practices.
GPs also recognize the benefits of co-investments. An LP can provide valuable capital for a large transaction for which the GP’s equity may not be sufficient, or the size of the transaction exceeds the funds limit for a particular industry or geography. More importantly, GPs prefer to share these deals with their LPs rather than with other competitors.
The obvious benefits of co-investment mean that competition between LPs for a GP is fierce. LPs have a voracious appetite for co-investments – some of the biggest LPs, with checks over $500 million, see fund investments as a way to end co-investment. They want a funds/co-investment ratio of 1:1 or more. At the same time, 37% of LPs cite the lack of available opportunities as a barrier to co-investing.
Many GPs complain that their LPs require co-investments but lack the capacity to support the process.
GPs now engage in an implicit selection process that favors proven GPs. With multiple LPs capable of making a big check, they must now compete for the best opportunities with their top GPs.
Get the deal
Researchers at Milken Institute‘s Asia Center interviewed the Chief Investment Officers (CIOs) of 8 major sovereign wealth funds and pension funds. Under Chatham House rules, CIOs — who collectively manage investments worth more than $2.4 trillion — shared what LPs can do to land that deal.
1. “Moving from business relationship building to strategic relationships with GPs”
Successful LPs identified GPs they believed in and nurtured relationships with them. One LP did this by becoming a trusted advisor. When a GP was raising a new fund, that LP advised them on the fundraising landscape, which led the GP to change their strategy.
Another investor sends the flow of reverse transactions to selected GPs, sharing the bargains they are unable to pursue. Similarly, an insurance fund, which is part of a large corporation, helps establish business partnerships between GP portfolio companies and their own subsidiaries.
For co-investments in particular, a pension fund agrees to invest 10-15% in new funds launched by its general practitioners in exchange for a co-investment. They also commit to supporting GPs on transactions that do not fit an asset class perfectly – such as complex transactions with a credit component – and are often rejected by other LPs for this reason.
This LP even went so far as to say, “On occasion, we may accept a lower yield on a deal because the deal itself is good for us.”
2. “A firm yes and a quick no”
After investing heavily in building relationships with selected GPs, successful LPs act with agility during the co-investment process itself.
“We follow a simple ‘yes firm, no quick’ rule when presented with co-investments. We can’t say yes first and then raise an issue on day one in week four,” said a sovereign wealth fund that has become one of the world’s most active co-investors.
Similarly, to become more agile, a pension fund changed its governance from requiring board approval for individual transactions to allowing investment teams to make decisions. They said, “Our council meets 5 to 6 times a year. If you are tied to this schedule, decision making takes a lot of time.
At the same time, to comply with their governance standards, the investment teams only have decision-making autonomy for transactions with a defined group of strategic partner GPs.
3. “Don’t insist on being in the trading room all the time”
In interviews, LPs emphasized the importance of maintaining trust throughout the co-investment process.
They referred to specific examples of bad practice they had witnessed and actively chosen to avoid, such as requiring GPs to perform inappropriate conditions. They also said it was unfair to say yes initially and then change your mind if market sentiment changed four weeks later.
“Drop the ego. Trust that your GP represents your interests,” said one investor, who added that he need not always be in the trading room or trying to to dominate the negotiation within the framework of a unionized agreement.
These recommendations should help any LP build their track record and successfully participate in co-investments.
Ultimately, private equity is a relationship business, and the relationship between an LP and a GP becomes even more important during the co-investment process.
Successful LPs will recognize this and act on it, generate superior returns and in turn build a future-ready portfolio.