Private equity co-investment looks like a great deal for limited partners. But Martin Steward finds that it is demanding enough to require intermediation, even for large investors with established general partner networks

When Alan MacKay agreed to take the job as CEO of Hermes GPE - a joint venture between Hermes Fund Managers and Gartmore’s private equity business - he was clear about his main condition: he wanted to build on Gartmore’s specific heritage in co-investments.

“Everybody here is co-invest competent - we are one of very, very few co-invest-led private equity businesses in the world,” he says. “We would advise all of our clients that the prime opportunity for the next decade in private equity would be to rebalance away from funds and towards co-invest.”

He seems to be preaching to the converted. A recent Preqin survey suggests that almost two-thirds of private equity investors intend to increase their co-investment activity - with public pension funds among the most enthusiastic.

The usual way to invest in private equity is to commit capital to a limited partnership vehicle, which gradually gets drawn down and invested in a diverse portfolio of companies. Fees vary, but limited partners (LPs) generally pay a 2% management fee and 20% carried interest. Co-investment, by contrast, involves the private equity manager approaching an investor or investors with an opportunity to invest in a single company outside the limited partnership structure. Again, fees vary - but nearly all are based on zero fees and zero carried interest.

You may have to read that sentence again. Co-investment is free. Even if you get access through an intermediary like your fund of funds provider - most of which have set 10-20% of their portfolios for co-investment, some of which offer dedicated vehicles - their fees work out considerably less than the 2-and-20 you’d pay on a GP’s primary fund. This is as close to a ‘no-brainer’ as you get in investment.

“One element the institutional investor community has control over is fee load,” says Claudio Siniscalco, a principal at Harbourvest. “That’s creating more of a focus on co-investment, whether that’s direct at zero-fee or through an intermediary at reduced fees.”

David Smith - co-head of the co-investment team at Capital Dynamics that traces its history back to 1990 with GE capital - agrees. “It represents great value: co-investment is perhaps the ‘Aldi’ of private equity.”

But there is more to this than fees. “Costs really do drive this for some of the larger investors, especially the new entrants,” observes Robert Durden, managing director in private assets at Morgan Creek Capital Management. “But the endowments and Canadian pension funds who set the standards for co-investment would point to their ability to control the pace of capital deployment, mitigate the j-curve, and control their own risk. It is also complementary to a primary fund programme, in that diligence on the deals your GP offers enables you to understand your GP that much better.”

This latter point is picked up by Smith at Capital Dynamics - where around 85% of co-investments are with managers the firm invests with as an LP. Selecting private equity fund managers and selecting private company managers are “different but complementary” disciplines: “What we see is a long way from the choreographed production that you see when GPs are fund-raising,” he says. “Having primary commitments gives the co-investment team access,” explains his colleague John Gripton, head of investment management in Europe. “While having the co-investment team working on direct investments with those managers gives us good, independent intelligence about how that manager works.”

Dennis McCrary, partner and head of the co-investment committee at Pantheon Ventues, agrees that a credible private equity programme depends upon bringing co-investment, secondary and primary fund capabilities together. “I think you are better at each one of those to the extent that you engage seriously in the others,” he reasons. “The quality of a co-investment programme reflects the quality of the managers from whom you see transactions - as well as your ability to select from the deals they offer.”

Where’s the catch? It is natural for investors to wonder what motivates managers to give these opportunities away. Co-investment might be the Aldi of private equity - but are Aldi’s cornflakes really the same as Kellogg’s?

Some do use it as a loss leader - “In a more challenging fundraising environment this is one way of securing capital without offering fee terms that may impact all investors,” says Sanjay Mistry, director of private equity funds of funds at Mercer - but the perception among most investors is that the main reason for offering these deals is their sheer size.

Most LP funds have a concentration limit for equity in individual deals. Let’s say a GP runs a $1.5bn fund with a $150m limit on each deal, and has bought nine companies with enterprise values of around $300m with equity cheques of $150m topped up with debt at $150m. Then a great opportunity to buy a $400m company turns up. The GP will probably put LP money in to the limit of $150m, and borrow $100m. For the missing $150m it will offer two or three of its LPs co-investment outside the fund. Those LPs pay the standard 2-and-20 on their investment via the fund, and get the other chunk for free.

So co-investments tend to be larger than deals in the same manager’s LP-funds - typically 1.6-times larger, according to Capital Dynamics. That sort of differential should not cause any problems - but larger deals are not without risk. For a start, they tend to attract more competition - and therefore higher bids. And the fact that a GP can do wonders with $300m companies does not necessarily mean that its skills and processes will translate readily to a $600m business. “Both of these things can result in value destruction,” warns Mistry at Mercer.

If deals start to get really big, investors begin to worry about how many co-investors they are going to have to share it with - and who exactly those other co-investors are. McCrary notes that his six-strong dedicated co-investment team at Pantheon has been casting a somewhat sceptical eye over a $600m equity deal offered by a manager whose LP fund is restricted to equity positions of around $100m, which has had to go beyond its LP network to other investors that are “known for writing big cheques”.

“That is beginning to look like a syndication - with the potential to bring in other private equity firms that would have to sit on the board,” he says. “If you get several investors assuming different roles - from totally passive to very active - you have to pay attention to who is really in control.”

Still, as McCrary adds, deal size rarely presents genuine problems such as these, and ‘too big for the fund’ need not mean too big for the manager: as funds pass their peak investment period and capital is returned to LPs, new deals are clearly more likely to run up against concentration limits even if they are no bigger than before. And, as we all know, credit is tight at the moment: pre-crisis, a $500m deal would have transacted as $100m equity and $400m debt; now that’s more likely to be a 50/50 split, which again means greater likelihood of hitting fund equity concentration limits.

Indeed, many GPs claim that size is far from their main motivation in offering co-investments. Aaron Rudberg, director of business development at Baird Private Equity, finds bizarre the idea that his firm would go off-piste for businesses where they have scant experience just to put bigger deals into their LP funds. Baird’s co-investments are the same size as its LP-fund deals, and a chunk of pretty much every deal in the LP funds is offered, fee-free, for co-investment.

“It’s more about building relationships then about deal size,” he says. “Having skin in the game takes the relationship to a new level, beyond being an LP in a fund.”

As large investors consolidate their network of GP relationships, staying on that shortening list is a priority. Offering ‘zero-and-zero’ deals helps, of course, but the sort of hands-on partnership that co-investment nurtures can make even more of a difference.

Some GPs look for added value on top of that. Rudberg says that Baird will look for advice and input from those LPs that it thinks have relevant experience or expertise before identifying and pursuing a transaction. “We look for those who can bring something besides their capital,” he says. “Perhaps a very large family office, for example, which has direct operating experience in the industry that we’re working with. They are often the most active co-investors, and we certainly get more value from them that way than as mere fund LPs.”

And that added value is not all ‘soft’. “Particularly when the deal is somewhat larger than they would normally do, our capital and our input is vital in making GPs credible bidders,” says Neil Harper, private equity fund of funds portfolio manager at Morgan Stanley Alternative Investment Partners (AIP), which has made around 100 co-investments worth $1.6bn over the last decade. MacKay at Hermes GPE agrees that involvement in pre-deal syndication is a “significant contribution” to helping GPs’ bids transaction: “GPs respond well to such a collaborative approach.”

From the co-investor’s perspective, better relationships means better understanding of a GP’s strengths and weaknesses - and greater likelihood of seeing the manager’s choicest deals. “Without long-established, deep relationships with established GPs, you won’t get the right kind of deal flow to make a co-investment strategy work,” argues Smith. And the more pro-active a co-investor is - some bring their own deals for GPs to consider - the more likely they are to get better performance from their deals, or at least performance that is “more differentiated” from “the purely-syndicated co-investment business”, as Sinscalco at HarbourVest puts it.

Finally, while the best co-investors are deeply engaged in both sourcing and monitoring deals, they tend not to be interfering busybodies. Unlike rival managers, who may want to sit on boards and impose their own philosophy, LPs have already approved their GP’s approach to business when they signed-up for its fund.

Some warn about pushing co-investment too far - if your free co-investments start to dwarf your paying LP commitments, Siniscalco asks, what’s really in it for your GP? - and it is natural for investors to ask about ‘negative selection bias’ when they appear to be getting deals free of charge. Without the deal-selection input of an intermediary, Siniscalco reckons that, “especially among the syndicated deals, there is a slight adverse selection bias”. MacKay at Hermes GPE - which selects only about 20 of the 130 or so deals it sees every year - warns of the “inherent risk of adverse selection” in co-investment.

But the motivation for GPs to offer co-investments and for LPs to allocate capital does seem generally constructive and well-aligned. It is clearly in the interests of intermediaries to talk up the pitfalls and their expertise in skirting around them, but there are still plenty of fund-of-funds providers who are willing, like McCrary at Pantheon, to point out that GPs would be crazy to risk a relationship-building exercise by offering co-investment in weak businesses. Or, as Smith at Capital Dynamics puts it: “We very rarely see what we perceive as a dud co-investment.”

According to Preqin’s findings, investors go into co-investment expecting better returns in excess of the reduced-fee benefit and have come out the other end with that expectation vindicated. One fund of funds said that, out of 57 deals brought to it for co-investment consideration, 28 performed better than the fund from which they came and 29 performed worse; the average multiple from the 57 was 1.29-times, versus 1.32-times averaged across all 450 transactions in the funds from which they came. Despite the lower fees, GPs don’t seem to be offering “duds” - or otherwise abusing the co-investment option.

For big, sought-after pension funds with their own networks of GPs, that raises the question of whether they need to engage intermediaries to source co-investments at all. The 0.5-1.0% management fee and 10% carried interest that a fund of funds will charge is lower than the 2-and-20 of a primary LP fund investment - but it’s not ‘zero-and-zero’.
“That’s quite a lot,” insists Luba Nikulina, global head of private markets at Towers Watson. “In reality, if you have the governance structure and size you can build up the internal expertise for less than that - so going direct with the GP is definitely the preferred route if you can build the capability in-house.”

That is a big ‘if’, of course. Co-investment is not just about being able to make informed decisions about private equity managers, or even about the management of companies. It is about being able to make those decisions quickly. The time from the initial offer to co-invest to the closure of the transaction is commonly 12-14 weeks, and GPs will often look for a verbal commitment within as little as 2-3 weeks. After all, they may be bidding competitively, and several co-investors may be waiting on one other’s decisions.

“As LPs, the last thing we want is for deals to drag on or even not come to terms because other co-investors’ decision-making processes are not up-to-speed,” says managing director Katharina Lichtner of Capital Dynamics. “There is a reason why GPs are ruthless on timeliness.”

Could fund-of-fund providers offer an advisory service for investors who have their own network of GPs, helping them both to be more pro-active in sourcing deals from their managers and performing the due diligence necessary on the deals they are offered - but at a lower cost than an asset management mandate?

That model has becoming more prevalent in North America, although Harper at AIP questions whether this can really address the timeliness issue, given that, in an advisory role, “we wouldn’t be able to speak for that capital ourselves”.

A further argument in favour of intermediation revolves around the probability that a fund of fund’s universe of approved GPs will be larger than any single pension fund’s. That means that the sheer number of co-investments offered will be greater - reducing the temptation to take any deal offered, ad-hoc. But it also means better manager diversification and generally enhanced capacity for risk management via portfolio construction.

“A co-investment portfolio is similar to a direct fund in terms of company risk - you have perhaps 15 companies versus as many as 200 in a fund of funds,” Lichtner explains. “But it is similar to a fund of funds in terms of manager risk, because you could have each of those company exposures with a separate manager. And our research on the benefits of manager diversification in private equity suggests that it is considerable.”

Indeed, for that very reason some funds of funds that are prepared to take on advisory mandates from investors prefer, like Pantheon, to combine co-investments from their clients’ GPs with co-investment from their own. Others, like AIP, insist that advisory or segregated account clients have a network of GPs that is “sufficiently broad”, as Harper puts it, “to ensure appropriate risk diversification”.

So there are genuine arguments for intermediation even if you believe that overall deal selection bias on the part of GPs is broadly neutral. But you will save on fees either way - so intermediaries have to show that they can improve diversification and enhance returns. That’s a tall order, given that the average quality of these deals seems to be high already.

“We haven’t been overwhelmed by the quality of some of the co-investment groups we’ve seen, and the returns haven’t been additive,” notes Mistry at Mercer. “For some low quality offerings there is an element of a tick-box exercise - and for now there are only a handful of groups that we are comfortable with undertaking this for our clients.”