Commonly held wisdom today says mature and maturing LPs will seek robust co-investment, often in the auspices of lowering the fee impact of the asset class.
Of course, not all co-investing is created equal. Various internal and external factors influence whether limited partners can see some or all of the benefits co-investing offers.
Affiliate Private Equity International spoke with Yup Kim, investment director and head of investments, private equity, at California Public Employees’ Retirement System, about what it takes to be a successful co-investor, and what LPs should seek to gain from co-investing. The $490 billion state pension is a bellwether LP that often sets the standard for private equity investing.
“I think every LP endeavors to build an in-house co-investment capability,” Kim says. “But as evidenced by many conversations with frustrated GPs, many are not able to execute.”
While the clamor for co-investment does not translate unilaterally into execution ability, an increasing number of allocators who historically only invested in funds are arming themselves with tools needed to directly invest via co-investment.
Co-investment opportunities are more bountiful at the top of a cycle, given that swollen valuations require more broadly syndicated deals. With rates poised for a hike, that dynamic seems precarious. Port-of-call LPs will enjoy continued access should the deal pool shrink.
Part of being a port-of-call LP depends on AUM and relationships, but LPs also need to demonstrate the ability to a) build conviction quickly, b) ask the right questions, and c) execute their strategy swiftly and effectively. To achieve this, LPs will need to reach into their pockets to find dedicated
co-investment professionals well-versed in the way general partners operate.
Out of such a structure grows specialization and eventually domain expertise, plus the ability to act on specific sector and macroeconomic trends.
“Over time, the hope is that not only do you accrue fee savings from co-investments as a lower-cost indexed approach,” Kim says, “but you’re also able to generate real alpha to the overall program returns as a result of focused, proactive company selection.”
Tremendous value can also be created from co-investment, both by the act itself and in a more enduring context. The action “becomes an active, ongoing series of diligence” that can deepen and strengthen a relationship with the highest-conviction partners, says Kim. This serves as a reliable window into a GP’s underwriting process outside of the fundraising cycle.
Strong co-investment relationships can also be an insurance policy against a downturn. Without resilient connective tissue between organizations, it will be difficult for GPs to advocate for opportunities during riskier times.
For its part, CalPERS has an ambition to make itself a more attractive partner in co-investment relationships, PEI understands. It enjoys a wealth of data from links with GPs that could enhance its partnership value.
The state pension also ducks another potential pitfall for investors in its class: allocation limits. While some endowments can have allocations as high as 40 percent, most state pensions are closer to single-digit or high/mid-teen allocations. Already, CalPERS sits roughly 3 percent below its target allocation of 13 percent. In light of recent secondaries market news, it could continue to have large sums of capital to deploy.