The advantages of private equity co-investments

For some time now, co-investing covers one of the fastest growing strategies within private market investing. Co-investments, typically alongside private equity managers, offer sophisticated institutional investors and high net-worth individuals the opportunity to gain faster and greater exposure to attractive assets but at better terms — thus providing the potential to achieve more attractive returns. Additionally, and especially when investing in a well-diversified portfolio of co-investments, investors are more diversified across deals and sponsors, thereby decreasing the overall risk and potentially improving risk-adjusted returns even further.

Investors or limited partners (LPs) are increasingly enticed by co-investments’ potential for higher expected returns, which is largely a function of lower fees. Providers not only charge lower management and performance fees but also offer risk management benefits, such as additional due diligence, active portfolio construction and a broader diversification across assets.

In a syndication process, a general partner (GP) has already closed or is in the process of closing an investment prior to offering co-invest. Syndication processes are typically expedited since the GP has already negotiated the final terms of the transaction. Syndicated co-investments may be available to small investors who can react quickly. The information received in terms of due diligence materials are standardized with limited ability by the LP to shape diligence or the transaction terms.

Typically, a GP may approach a sophisticated LP to go after an asset together where deal dynamics are uncertain and the asset may not be won. The LP needs to have a team with direct transaction experience who can sign equity commitment letters in pre-bid situations. The GP looks for an LP who is respectful of timelines, has an experienced team with deep domain expertise. LP has much stronger influence on the transaction structure, pricing and terms, as well as deeper insights into the transaction.

Probability distributions of net multiples

Visually, the above graphic shows that the left tail of the probability distributions is truncated dramatically when moving from primary funds to synthetic and to actual co-investment funds while offering more upside in the right tail. This clearly speaks for very strong risk-adjusted returns and explains in part the success and growth of co-investments.

This work lays out the growth and evolution of the private equity co-investment market in addition to providing an empirical analysis of simulated co-investment funds compared to traditional primary funds across various market cycles. In a search for alpha, institutional investors have increased allocations to private equity in order to meet return targets. In this quest for alpha, investors have increasingly turned to co-investments to better control portfolio construction in addition to obtaining access to attractive investments at an improved fee basis. This paper finds the market still has room to grow given the advantages to both the GP and the LP taking into consideration the performance impact of the private equity premium, fee savings and selection of investments.