Advantages of Co-Investments as Private-Equity Capital Becomes Scarce

In the realm of investment, co-investments have emerged as a strategic approach that not only offers enhanced transparency and control but also holds the potential for elevated returns. Particularly significant within the domain of private equity (PE), co-investments provide a unique opportunity for investors to directly participate in specific deals alongside PE funds, granting them a level of visibility and influence that traditional investment avenues often lack.

Empowering Investors through PE Co-Investments

In sharp contrast to the conventional model of committing to long-term PE funds spanning 8 to 12 years, where investors often lack insight into the companies targeted for acquisition, co-investments present a distinctive proposition. Co-investors are afforded the chance to collaborate with PE managers and general partners (GPs) to invest in meticulously selected deals. This partnership not only guarantees visibility into the investment process but also preserves the discretion that investors seek.

Navigating Turbulent Waters: The Rise of Co-Investing

In the quest for novel capital sources, fund managers find themselves turning to co-investments as a viable solution. Simultaneously, investors are drawn to this avenue as it offers a means to reduce the financial burden of fees. According to Pitchbook data, the total capital raised for co-investments alongside PE managers surged from $4 billion in 2010 to an impressive $10.3 billion in 2022. This trend is projected to continue, with co-investments potentially capitalizing on the prevailing environment of subdued fundraising activities.

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Adapting to Industry Shifts: Co-Investment in a Changing Landscape

The year 2022 witnessed a substantial decrease in the number of private equity funds, dropping from 1,129 to 597. This shift was driven by a cautious approach adopted by limited partners (LPs) who focused on experienced managers. Consequently, emerging managers encountered formidable challenges, with fundraising for inaugural private equity funds hitting a nine-year low. To bridge the equity gap, general partners (GPs) turned to co-investments. This strategy not only addressed the immediate funding requirements but also allowed GPs to allocate more time to raising subsequent commingled funds. Additionally, co-investments facilitated portfolio diversification and extended investment periods, providing the flexibility to stay out of the market for longer durations.

Meeting the Demand: Co-Investments in a Scarce Debt Environment

The scarcity of debt in 2022 further fueled the demand for co-investments. This demand was propelled not only by LPs’ inclination to minimize fees but also by the escalating cost of debt financing for buyouts. This phenomenon was a result of the tightening credit market and elevated interest rates.

Family Offices: Pioneering the Co-Investment Frontier

The allure of co-investments extends to family offices, with nearly two-thirds of institutional investors planning direct investment collaborations with their GPs in the coming year. Family offices have embraced co-investment strategies, which can take various forms such as “club” deals uniting multiple families for joint investments, investing alongside PE funds but not directly in them, and partnering with other families for business investments. Globally, 42.5% of family offices are already active in co-investment endeavors. Unlike institutional investing, the family office industry embraces a more personal and relationship-centric approach, leading to collaborative investments and shared opportunities.

Embracing the Benefits of Co-Investing

For general partners, co-investments unlock the potential to allocate more capital to promising companies, overcoming the limitations imposed by concentration constraints. On the investor side, co-investments provide a focused avenue, granting them direct access to outstanding private firms rather than dispersing investments across numerous companies through fund-of-funds structures. These structures often entail a lengthy investment period of up to seven years. Typically, co-investments encompass investments in 25 to 30 companies spanning diverse GPs, countries, and industries, while still maintaining an optimal level of diversification. Moreover, co-investments typically come devoid of management or performance fees, amplifying the net return in an asset class recognized for its substantial fees.

Navigating Challenges and Pitfalls

While co-investing garners favor among investors seeking greater control and engagement in their investments, challenges abound. Many investors seek a more active role, moving beyond passive fund investment to securing a seat at the decision-making table and direct involvement in target businesses. Yet, the co-investor market has experienced saturation, resulting in varying levels of co-investor quality.

Addressing Conflicts and Regulatory Considerations

The predominance of “passive” co-investors, who do not lead or underwrite deals, has garnered the attention of regulatory bodies such as the SEC. Efforts are underway to introduce new regulations that account for these discrepancies. Additionally, potential conflicts of interest can arise. GPs may allocate a disproportionate number of co-investment opportunities to potential future fund investors, creating an uneven playing field. Furthermore, the dilution of stakes for major fund investors by co-investors can trigger conflicts within the fund structure.

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Conclusion: Navigating the Co-Investment Landscape

In summary, co-investments offer a compelling avenue for investors to collaborate directly with PE funds, unlocking transparency, control, and the potential for superior returns. Specifically, PE co-investments provide a gateway for investors to support specific deals alongside managers, fostering both visibility and discretion. As the investment landscape evolves, co-investments emerge as a strategic choice, presenting benefits and challenges that demand careful consideration.

Source: https://www.wsj.com/articles/co-investors-to-benefit-as-private-equity-capital-grows-scarce-11672958428