Amid market shifts, regulatory scrutiny, and technological innovations, co-investments in private equity are undergoing a transformative change, writes Chase Collum. Here are five takes on the strategy.
1A resilient option in uncertain times
Investors can’t afford to merely seek shelter from the storm; they need exposure to companies and sectors that are growing.
Perhaps that’s why the co-investment strategy often surges in popularity during times of financial stress. “In almost every economic cycle over the past three decades, we have seen that the more challenging the macro backdrop, the greater the demand for co-investment from GPs,” says David Smith, senior managing director at Capital Dynamics. “This shows the resilience of co-investments in weathering economic storms.”
Co-investments provide a means for GPs to continue cultivating relationships with LPs, especially during periods when fundraising is muted. Seth Palmer from HarbourVest captures this sentiment well, noting: “GPs recognize that capital to support new fundraisings is scarce, and one way to capture those scarce dollars is to deepen relationships with strategic partners by offering fee-free, carry-free co-investments.”
Steven Hartt, managing principal of Meketa, adds: “Co-investment allows LPs to get more money distributed to their favored managers, and with little or no fees and carry attached.”
The bottom line, as stated by David Brett, partner and head of co-investments at Adams Street Partners: “Co-investments continue to be a very important part of many investors’ private equity strategies.”
2 An evolving strategy
Co-investments have become a crucial source of GP equity capital, particularly when many investors are sidelined due to over-allocation.
“Demand for co-investment has grown dramatically over the past two decades,” says David Stonberg, deputy head of alternatives and the global co-head of private equity co-investments at Neuberger Berman. “Co-investment has evolved from a haphazard, episodic set of investment opportunities offered to LPs by GPs to a main source of equity capital for those GPs to get their transactions done.”
Joana Rocha Scaff, head of European private equity at Neuberger Berman, highlights another rising trend. “We are also seeing more mid-life co-investment opportunities – the provision of capital to existing portfolio companies in order to support growth strategies or generate liquidity,” she says. “Demand for those mid-life solutions has certainly proliferated over the past 12-18 months.”
3 Growing in transparency
Valuations have remained steady in the face of turbulence. But in one respect, the value proposition has perhaps shifted in the favor of the buyers.
“Prices may not be significantly lower but the level of knowledge and conviction you can take into a transaction is significantly higher,” says Rocha Scaff. A rise in bilateral processes with “far fewer full-blown auctions,” she adds, “has resulted in materially better access to information and better access to the management of the underlying company, which is extremely important in terms of investment decision making.”
The industry appears to be self-auditing in anticipation of regulatory action. The SEC is setting its sights on co-investment transparency, particularly concerning the allocation of broken deal expenses. “We’re all waiting to see if the SEC will introduce rules to prohibit non pro rata allocations,” says Kate Ashton, a partner at Debevoise & Plimpton.
Transparency is of rising importance in the GP-LP relationship, especially in a tough fundraising environment. “Even the strongest GPs are taking longer to raise capital, so they are keen on maintaining good relations with their investors,” Ashton adds.
It appears that transparency is evolving from a ‘nice-to-have’ to a ‘must-have’ in co-investments, driven by regulatory uncertainty and strategic necessity. In an uncertain market, clarity is becoming an essential asset.
4 At the intersection of talent and technology
As in other areas of the private markets, specialization is rising up the agenda in co-investments. And that specialization is breeding demand for specific skills and toolkits.
Scott Garfield, Manulife Investment Management senior managing director of private equity and credit, says: “We think the trend of top PE firms becoming more specialized by sector and more operationally savvy will therefore accelerate.
“Specialization can lead to more proprietary deal sourcing, better risk assessment and deeper insight that fosters targeted value creation strategies for each investment. Evidence suggests specialization also helps drive returns.”
Top private equity firms are increasingly sector-focused and operationally savvy. This shift demands new skill sets, phasing out the traditional team of generalists in favor of specialists in data science, engineering and human capital management.
“Demand for co-investment has grown dramatically over the past two decades”
Garfield says: “The old model of PE firms populated by finance generalists bearing MBAs may no longer work; instead, talent with data science, engineering, human capital and other operationally relevant proficiencies are now more likely to drive profitability at portfolio companies.”
Meanwhile, generative AI and other emerging technologies are poised with the potential to revolutionize the sector. Garfield points out that Goldman Sachs estimates this technology could boost global GDP by nearly $7 trillion in the next decade, altering both investment strategies and business models.
5 The road ahead is not without challenges
From the limited partners’ viewpoint, co-investments introduce specific challenges that require capabilities for quick decision-making and proper underwriting. As the industry transforms, a new paradigm of talent and technology emerges, marked by specialization and advanced operational capabilities.
“Underwriting a co-investment is also different to underwriting a private equity fund and so different skill sets are required. Decision-making around co-investment tends to be more rapid than for fund commitments,” says Hartt of Meketa. While co-investments in private equity offer lucrative opportunities, barriers persist. Nearly half of LP respondents to the 2023 LP Perspectives Study by affiliate title Private Equity International said the speed required to conclude transactions was the biggest hindrance to executing co-investments. Meanwhile, 37 percent of respondents were hindered by required ticket sizes.
The rise of continuation funds is having a blurring effect on co-investments, adding further complexity and sparking conversations around how to categorize the two strategies as they share certain risks such as alignment of interests and credibility.
As traditional exits in private equity dwindle, continuation funds are poised for growth, further complicating the landscape for LPs and raising uncertainties about returns compared to traditional co-investments. As Carmela Mendoza notes in a recent Side Letter for Private Equity International, deal volume for continuation funds involving one asset is likely to grow even further given the dearth of exits within private equity, meaning LPs are likely to have a wealth of opportunities to partake in the strategy.