Co-investment: The LP’s story

LP appetite for co-investment has climbed steadily over the course of the past decade as investors seek to manage their allocations more actively and, critically, reduce fees and therefore enhance returns. “Co-investment allows LPs to get more money distributed to their favored managers, and with little or no fees and carry attached,” says Steven Hartt, managing principal at Meketa. “That has driven a significant amount of interest in recent years.”

“Putting aside those investors facing denominator and numerator problems, LPs are generally very interested in co-investing for tactical reasons,” adds Scott Martin, head of co-investments at Cambridge Associates. “They view co-investment as a way to generate alpha and as a way to access managers that they may not have been able to access in frothier times.”

Matt Swain, global CEO of Triago, adds that in addition to the ability to blend down fees, co-investment gives LPs greater control over their allocations, enabling them to go deeper on particular sectors or geographies, for example, which would not be possible in a blind pool fund.

“Similarly, in these uncertain times, having the opportunity to kick the tires on identifiable assets can offer greater reassurance than a blind pool scenario. Finally, co-investment can offer the opportunity for greater governance rights. If you are writing a large cheque, you can get more advantageous LPAs surrounding the individual asset or even a board seat. Groups such as CPP have built a whole model around this premise,” Swain says.

But while the appeal of co-investment is clear, not all LPs have the resources at their disposal that CPP does and accessing all the benefits that co-investment promises can be challenging.

“Putting aside those investors facing denominator and numerator problems, LPs are generally very interested in co-investing for tactical reasons”

Scott Martin
Cambridge Associates

“Team bandwidth is an issue. A lot of teams are small and lean and there isn’t enough resource to properly underwrite co-investment,” says Chris Webber, director at Monument Group. “Those investors generally leverage managers they have known for a long time and only co-invest with them.

“Underwriting a co-investment is also different to underwriting a private equity fund and so different skill sets are required. Equity check can be a challenge as well. Some investors may have a minimum equity check of $20 million, for example, but getting a $20 million allocation can be tough when there are a lot of mouths to feed.”

Meanwhile, the ability to move quickly is one of the biggest challenges that would-be co-investors face. “Decision-making around co-investment tends to be more rapid than for fund commitments,” says Hartt. “LPs have to ensure their processes match those timelines.”

“Co-investment is generally fast moving while investment offices are often understaffed,” agrees Martin. “That can result in decision-making paralysis. The basic analysis of the transactions is relatively simple but by the time you get into the tax and legal structuring issues, that can prove really challenging for some investors.”

Many institutions are therefore looking to formalize their programs in order to secure coveted co-investment. “We are increasingly seeing LPs organize their staff into dedicated co-investment teams in order to make sourcing, valuation and execution more efficient, even hiring directly from private equity to build out their resource,” says Hartt.

But for others the remuneration packages required to attract top talent make that unrealistic. “Some pension fund managers and multifamily offices are hiring in dedicated resource to cope with these issues but for many endowments and charitable organizations, for example, it simply isn’t possible to hire people of the appropriate caliber,” says Martin.

“We continue to see the larger, more mature institutional investors including pension funds evaluate building out their passive co-investment effort, which typically ebbs and flows with economic cycles,” adds Bart Osman, partner at Lexington Partners. “However, there is a whole list of challenges that can come with an in-house program, including concerns over deal sourcing and deal concentration, working on GP deal time, recruiting and retaining staff with relevant co-investment experience, and allocation issues.”

The allocation challenge

Indeed, the allocation of co-investment has been a hot topic ever since the Securities and Exchange Commission issued a risk alert in 2020, stating that GPs were not following their own policies governing the disclosure and allocation of co-investment in funds, creating conflicts of interest. The alert also stated that some GPs had agreements with certain investors to give them preferential access without adequate disclosure. The fallout has meant tensions between GPs and LPs, amid accusations of bias and feelings of marginalization.

As is so often the case, the solution lies in open communication. ILPA’s best practice recommendations call for GPs to be transparent with all LPs about co-investment allocation policies and practices. These should be disclosed in advance, through the PPM, LPA and regulatory filings.

“This is a difficult fundraising environment so even the strongest GPs are taking longer to raise capital and as a result are very conscious of remaining on good terms with their investors,” says Debevoise & Plimpton partner Kate Ashton. “That may mean giving them access to co-investment opportunities and will certainly mean making sure no one feels they are being prejudiced or disregarded in the allocation process.”

“Decision-making around co-investment tends to be more rapid than for fund commitments”

Steven Hartt
Meketa

Peter Martenson, managing director of GP advisory, secondaries and directs at Eaton Partners, part of Stifel Financial, adds: “There always has been and always will be tension around the allocation of co-investment, which is why we encourage our GP clients to put a systematic approach in place and to communicate that approach openly. Typically, that will involve a pro rata rate on your commitment to the fund with 15 days to make a decision. If that decision is a no, that investors’ portion of the co-investment will be reallocated to others.”

Martenson says that typically tensions only arise when an LP hasn’t been able to make a decision in the given timeframe and so asks for an extension. “GPs want to be fair, because they want to keep their investors happy, but they also need to close the co-investment in a timely manner in order to close on the deal.”

Meanwhile, although transparent allocation should theoretically have alleviated tensions with systemized processes, there are ways that potential co-investors can make themselves more attractive to GPs, thereby optimizing their position in the queue.

“Speed in underwriting is important as GPs can be up against a closing timeline. GPs need to know that you can act quickly and provide a fast yes or no, especially when the capital is needed to close the transaction,” says Webber.

Having an opinion can also help with access to deals. “In some cases, sponsors want passive capital. But equally, sponsors appreciate a co-investor that knows the space and may even offer them an observer seat on the board,” says Martenson. “It can be useful to have partners who can help move the company forward and identify potential bolt-ons, for example. That can really help to facilitate co-investment access.”

But above all, it is just as important for the LP to be open and honest about their desires and capabilities, as it is for the GP to be transparent about process.

“In order to make yourself attractive as a co-investor, be upfront about what you are looking for and what you can offer. Tell the GP the sectors you like and dislike. Tell them how much money you are looking to put to work in deals of what size. Tell them what return profile you are targeting from your co-investments and your time horizon for exit,” Martenson says. “Share that wish list with sponsors and then tell them how you work as a co-investor as well. Tell them you can give an answer in five days and then close in 30. That is how to get to the front of the line.”