Co-investment opportunities are inevitably and inextricably linked to overall private equity volumes. And given current macroeconomic and geopolitical upheaval, it is reasonable to expect that transaction levels are poised to sharply decline.
Dedicated co-investors are sanguine – and even bullish – about prospects for the next 12 months, however. Not least because sporadic and opportunistic co-investors have dialed down their appetite, with some exiting the market altogether.
“We are seeing significantly more opportunities than we would have anticipated at the end of Q1, largely because a number of unstructured co-investors have stepped back,” says HarbourVest managing director Craig MacDonald, citing the example of family offices where the principal has grown more risk-averse, or small teams without the resource to carry out the additional digging required in a volatile environment.
“Some investors are capital constrained due to the volume of re-ups they have been experiencing and where we are in the cycle,” adds James Pitt, partner at Lexington Partners.
Arslan Mian, managing director, Private Equity Partners at BlackRock, agrees: “In the recent volatile environment, we have seen some pullback from less experienced co-investors, potentially due to troubled portfolio companies, an inability to manage more cumbersome and complex transactions and a lack of dedicated pools of capital.”
Meanwhile, Alexandre Motte, managing director and head of co-investment at Ardian, points to a transaction signed in May when the firm was told no syndication capacity was available. “Last month, that GP called us back and said there is now room, which clearly means that some of the initial LPs decided not to go ahead.”
And while reduced private equity investment volumes will undoubtedly dampen co-investment supply, there are also trends working in co-investors’ favor. In particular, the prospect of a more challenging fundraising market could see sponsors take longer to amass capital and fall short on targets, both impacting the scale of equity ticket they may be willing to deploy. At the same time, debt markets are tightening, increasing the amount of overall equity required to seal a deal.
“Overall, volume of deals is by far the biggest force that impacts co-investment supply,” says Matt Shafer, managing director and global head of direct private equity at Northleaf Capital Partners. “But there are offsetting positive drivers of opportunity as well. Debt markets are more constrained, which increases the amount of equity required to complete deals. And with more pressure on fundraising, sponsors may rely more on co-investment capital for investments.”
A challenging environment
Ardian’s Alexandre Motte explains that the current market is particularly testing for those co-investors that may only complete two or three deals a year.
“We are currently running at around half our typical pace, which means we may complete eight or nine co-investments in 2022.
“If we make one mistake, that is manageable. But for a smaller, less structured player making one or two deals annually, a single mistake could be very damaging. That is leading some groups whose primary activity is fund investment, where it is very difficult to lose money, to press pause on co-investment.”
MacDonald agrees: “While a number of managers raised very successfully in the first half of 2022, I think it is safe to assume that fundraising may slow in the back half of the year and remain challenging in 2023. As a result, some firms have now delayed their fundraising plans, which should lead to an increase in supply of co-investment.”
In addition, GPs may be willing to award larger co-investment allocations, not only to compensate for reduced equity tickets from current funds, but also to curry favor with the LPs they hope will support their new funds when they are eventually launched. “As fundraising becomes more challenging, firms may want to offer increased co-investment, both due to smaller fund sizes and to please their LPs,” says Motte. “Debt may also become scarcer as banks pull back, further increasing demand for co-investment.”
Furthermore, Motte believes that lessons painfully learned during the global financial crisis mean that sponsors will strongly favor additional LP co-investment over co-underwriting with fellow GPs.
Mian agrees. “Filling an equity gap with LP co-investment provides for more aligned governance than sharing control with another GP, and GPs may prefer sharing the upside with their LPs rather than a competitor,” he says.
Selectivity is key
Despite the deluge of dealflow, co-investors are understandably being more selective than ever. “We have always been very consistent in the pacing of our funds – a discipline reinforced by the GFC – and we have continued to invest through 2022,” says MacDonald. “That said, we have certainly said no to more opportunities than we have historically.”
Co-investors are particularly wary of overpaying and are reluctant to take a slice of what Lexington’s Pitt describes as yesterday’s deals. “We are all trying to avoid deals that were priced a while back,” he notes.
Co-investors are also looking for businesses with strong pricing power and a good degree of locked-in revenues that are well placed to weather a recession, Pitt says, adding that Lexington is also focused on ensuring that appropriate capital structures are in place.
“We’ve applied some lessons learned from the GFC to our underwriting approach. Many buyouts done between 2006 and 2007 were priced at peak valuations and generated limited free cashflow to repay debt in the first year or two, posing challenges heading into the recession,” adds Andrew Farris, managing director, Private Equity Partners at BlackRock.
“Many of those deals were longer holds and faced multiple compression at exit as valuations reverted towards historical norms. In recent years, we’ve been conscious of the parallels to the pre-GFC environment, with buyouts again being done at heightened valuations and leverage levels. Our underwriting has emphasized free cashflow, potential multiple compression and recession impact.”
Motte also sees echoes of the GFC in the current environment and believes that leverage and the ability to pass on inflationary price increases are two of the most important considerations today. “Our experience in the last crisis showed that if debt levels are too high or if the right covenants are not in place, that significantly increases the risk of running into trouble,” he says. “We obviously also want to ensure that a company can pass price rises on. That means investing in businesses that sell products and services that are essential to their customers.”
Those fundamentals can exist in any sector. However, there are certain industries proving more popular with co-investors than others. Tech continues to be a major theme, due to the defensibility of the product, protection against inflation and strong cashflows. MacDonald, meanwhile, believes that financial services will also become an increasingly interesting theme as a result of rising interest rates.
Motte adds that healthcare is inevitably becoming hot property, given the commonly held assumption that healthcare spend remains a priority regardless of the macroeconomic context. He sounds a word of warning, however. “Governments have paid whatever was required during covid, but that may not necessarily always be the case.”
And while Motte acknowledges that the consumer goods sector is challenging, based on the confluence of supply chain disruption and a severe tightening on discretionary spend, he adds that pockets of opportunity remain. Ardian, for example, has invested alongside 3i in discount retailer Action. “That is a company that is performing very well because of its low price point. We don’t necessarily take a sector approach. We focus on understanding where a company is positioned in the value chain.”
There are also opportunities emerging to support portfolio companies mid-way through the life of an investment. And proactively engaging with managers to provide solutions for existing investee businesses is one way to increase the addressable market at a time when overall deal volumes may be down.
Sponsors may be looking for capital to help grow portfolio companies when the fund is constrained by size, concentration limits or the point it has reached in the investment life cycle. “In a more constrained market, working with existing portfolio companies to provide capital for growth or liquidity can create interesting opportunities,” Northfleaf’s Shafer says. “But you can’t wait for the GP to pick up the phone. You have to be proactive, work in partnership with sponsors and think like a financier to these companies. We take this approach to help our partners and create attractive outcomes for our investors.”
MacDonald says that private equity firms have been using co-investment as a tool to provide primary and secondary capital to their existing portfolio companies for some time. Particularly relevant examples right now include a sponsor looking to co-investors to provide follow-on funding to support a large add-on acquisition, he adds.
“We are seeing demand for this type of co-invest in order to bridge the funding gap as debt becomes significantly more expensive,” he says. “While these types of opportunities inherently create misalignment with the sponsor, if structured and executed properly, they can provide an attractive risk-return proposition to invest in calibrated and prized assets with minimal disruption to the existing ownership and governance dynamics.”
Motte, however, is more circumspect. “We believe co-investment needs to have complete alignment with the GP. We want to enter at the same valuation and exit at the same valuation. We see that as an important feature,” he says.
“We have sometimes been contacted by a GP that wants to sell part of their stake or that requires fresh equity, but we have typically declined. One reason is the lack of alignment. The other is that we feel if new money is required, the GP should find a way to finance at least part of that. The fact they are turning to co-investors raises difficult questions.”
What is clear is that despite an unprecedented confluence of macroeconomic and geopolitical headwinds, which will almost certainly put a damper on direct dealflow, dedicated co-investment teams are bullish.
“While there may be some decline in the overall level of private equity activity, I don’t think we will see a direct correlation in terms of a decline in co-investment deployment,” says MacDonald. “We expect co-investment should remain stable and perhaps even increase as GPs look to supplement their funds.”
Pitt adds: “Overall, the evolution of supply-demand dynamics is benefiting us in terms of dealflow. This is an exciting time to be a co-investor.”