Co-investment sustains over the longer term

Amid the ongoing flight to quality, private equity investors’ appetite for co-investments remains unchanged year on year. According to affiliate publication Private Equity International’s LP Perspectives 2023 Study, 64 percent of LPs plan to participate in co-investment opportunities over the next 12 months.

This broader theme of LPs wanting greater control over the direction of portfolio companies isn’t new – although appetite has waned in recent years, from a high of 73 percent in the 2019 study, Perspectives data shows.

Against a highly uncertain market backdrop this year, LPs looking at a transaction today cannot ignore interest rates, inflation and the pricing power of portfolio companies, Patrick Kocsi, Ardian’s head of US co-investment, said in a co-investing roundtable with PEI in October.

“While today’s headlines are not to be ignored and you have to take them seriously, we take a view of what happens long term”

Patrick Kocsi
Ardian

“These are the things we do underwrite. We’re investing for a three- to five- to seven-year time horizon. While today’s headlines are not to be ignored and you have to take them seriously, we take a view of what happens long term,” said Kocsi. “We underwrite recession scenarios and we build in a multiple decline upon the exit. We all know that forecasts are wrong the moment the Excel is dry, but we build those things in to give us an idea.”

Kocsi added that co-investors are “very focused” on the underlying leverage of the company, noting that the firm has seen a number of transactions with debt providers pulling back at the last minute.

There’s also a sense that the macro outlook could worsen before it gets better. Philip Smelt, a principal at Lexington Partners and a participant at the roundtable, said: “While deal execution will certainly continue, we expect the pace of deal-doing to remain somewhat constrained over the coming quarters.”

The amount of capital flowing into dedicated co-investment funds reached $13.4 billion in the year to end-September, per PEI data. Managers that have held final closes recently include Adams Street Partners, which gathered over $1.3 billion for Co-Investment Fund V, and StepStone Group, which hauled in $2.36 billion for StepStone Capital Partners Fund V.

Co-investors bullish on the strategy are seeing a flight to quality in the current environment. Erik Wong, a partner at Pantheon, said businesses that command a leading or differentiated market position, have a sticky revenue base and benefit from secular or structural growth will continue to attract strong interest.

“While valuations may be elevated for those assets, sponsors who have operational know-how and sector expertise should continue to be able to develop their investment angles and generate strong returns,” Wong said.
It’s important to note, however, that direct investing isn’t for all. Nearly half of LP respondents in the study say the speed required to conclude transactions is the biggest hindrance to executing co-investments, followed by the ticket size required (37 percent).

Interestingly, insufficient staffing was identified as the main barrier to LP participation in co-investment opportunities in last year’s study with 45 percent of respondents citing team capacity constraints as an issue, but this has now fallen to 33 percent.

The volume of deals is also affecting co-investment supply (27 percent), especially as reduced dealmaking volumes during the market downturn dampen the availability of co-investment dealflow.

Co-investors can position themselves to see dealflow by acting as a user-friendly and responsive counterparty for the sponsor, according to Lexington’s Smelt: “The ability to provide a strong, early signal – whether that is yes or no – is of real value to the sponsor in these processes.”

As participants in PEI’s roundtable noted, the timelines for co-investments can be very tight and GPs appreciate it when LPs understand what they are going through, talk on a peer-to-peer basis and get the deal done within a short timeframe, typically between two and six weeks.

Nonetheless, some LPs are doubling down on their co-investment programs. Last year, the Connecticut Retirement Plans and Trust Funds launched a dedicated co-investment program and selected HarbourVest Partners to run its private equity and private credit co-investments. Meanwhile, the California Public Employees’ Retirement System is seeking board approval for a policy that would allow it to participate in co-investments with institutional investors it does not partner with. The policy was set to be discussed at its November meeting.