Manulife: Co-investing demands micro rigor and macro perspective

Getting the decision right on a co-investment opportunity – participate or pass – is crucial, says Manulife Investment Management’s Scott Garfield.

This article is sponsored by Manulife Investment Management

Scott Garfield
Scott Garfield

Successfully executing a co-investment strategy is relatively straightforward, though in no way easy to accomplish. Whereas direct investing involves the full range of private equity activities – from sourcing through exit planning, from firm strategy through all elements of executing value-creation strategies, co-investing involves a more limited set of requirements: robust sourcing and effective investment selection are the ingredients for success.

Rarely can co-investments be originated proactively; instead, a co-investment program is largely reactive, dependent on private equity relationships for opportunities to participate in attractive transactions. Getting the decision right on a co-investment opportunity depends on three key criteria:

1 Alignment between the sponsor and its co-investors, and a strong match between the sponsor’s area of expertise and the company’s line of business. Even a co-investment in a fully valued company can succeed if it’s executed alongside a sponsor with the specialization and skill required to take the business to the next level.

2 Attractive company characteristics, such as consistent free cashflows, durable market positions and stable earnings growth that balance multiple value-creation levers with a measure of downside protection.

3 Portfolio diversification, with representation from different sectors, sponsors, investment strategies and risk exposures.

While investing on predictions isn’t prudent, understanding current economic, geopolitical and capital market conditions is essential in optimizing investment selection. In particular, what are the implications of today’s macro environment? We consult with our own economists, compare their views with other market analysts and integrate conversations with numerous general partners in our PE funds program.

Often, live deal activity provides real-time data on market conditions. Movements in credit spreads, borrowing terms and leverage, for example, are important considerations that we update weekly through discovery with our senior and junior credit teams.

To illustrate the point, take the disconnect that’s emerged between broadly syndicated loans (BSLs) and mid-market loans. Recent stress among BSLs juxtaposed with the relative stability of direct mid-market lending has been a co-investment underwriting consideration, biasing us for now toward smaller companies with lower leverage – particularly those with lower mid-market club lending structures where terms and pricing remain borrower-friendly.

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As we suspect is true of many other limited partners and co-investors, we relish the opportunity to absorb the assessments and opinions of a wide range of leading PE firms, investing across the gamut of industry verticals, underlining the implications they draw for their investment strategy and approach. NASDAQ down double-digits this quarter? What are leading software buyout firms saying about technology investing? Two quarters of negative GDP? How are North American middle market private equity sponsors responding in the industrial space?

Ultimately, investors should aim to build portfolios assuming only risks that are execution-related and controllable in nature – M&A integration, ERP implementations and other value-creation strategies – while steering clear of risks that can’t be controlled, such as those tied to customer concentration, regulatory change and commodity price swings. Business models poised for growth irrespective of economic conditions are always attractive, and they’re even more primed today.

Staffing businesses with large information technology practices might, on the surface, seem highly cyclical. However, prior mezzanine investments in such businesses revealed there’s been a secular change in IT staffing over recent years, such that it’s no longer so cyclical. Performance through the global financial crisis and pandemic periods suggested the cyclicality was muted and manageable.

A presence in direct lending, mezzanine, primary and secondary markets can create an information edge in private equity co-investing. Such affiliated programs often yield great insight into sponsor capabilities, sector risks and trends, and relative valuation metrics.

For instance, we participate in board meetings over the course of a junior credit investment as an observer alongside a particular sponsor and learn a great deal about that GP’s level of engagement and ability to add value. This directly informs our next co-investment opportunity with that firm. We gain a greater understanding of how a business may be affected by an exogenous event by reaching out to several of our GPs to hear how their former or current investments in that sector were affected by that same event. And, by casting a wide net across all the underlying transactions in our secondaries, private credit and primary funds programs, we develop a detailed view of key issues such as valuation, relative growth rates and margin sustainability.

An important dynamic for co-investing has emerged as GP-led secondaries have developed into a common private equity realization tool: whereas in the past, most exits were dictated by drag rights embedded in co-invest agreements, now co-investors are often faced with a decision: “Do I sell? Or do I hold and roll the exposure into a continuation vehicle?”

We recently had a situation where we faced just such a decision as LP and as co-investor. Meanwhile, our secondaries team colleagues were evaluating whether to participate in the new transaction. Their underwriting work added to our direct experience with the investment and helped inform our decision to realize the successful exit. No longer limited to when an investment goes public, the co-investor now must often be an active participant in the exit decision.

While most co-investors have no advantage in predicting the length of the business cycle or the amplitude of its peak or trough, they can demonstrate a discernable edge in choosing the best GPs with proven track records. A worthy co-investing objective is to build a diversified, resilient portfolio of investments that has a positively asymmetric set of expected return outcomes. If co-investors get that right, the odds typically line up in their favor regardless of macro and market conditions.

Scott Garfield is senior managing director, private equity and credit at Manulife Investment Management