The rise of co-investments

Now a parade of new research suggests LPs are bellying up to the bar. Co-investing has become an established part of the market, helping to drive down fees for LPs and giving them greater control over the makeup of their portfolios.

A survey of 137 institutional investors around the world last October by placement agency Probitas Partners found that more than a third (35 percent) have an “active” internal co-investment program, up from 22 percent found by a similar survey two years earlier, while just 30 percent say they don’t make co-investments at all. Among large investors, the percentage with active co-investment programs is even higher, 59 percent, up from 48 percent two years earlier. Probitas Partners defines large investors as those that plan to commit at least $500 million to private equity this year.

Meantime, according to a late March presentation by Michael Elio, partner at advisory shop StepStone, about a third of the aggregate amount invested in buyout deals around the world in 2012 included some co-investment capital. That was up from about 17 percent in 2008, and about even with the percentage seen in 2007, when deal sizes temporarily ballooned and sponsors found themselves eager to share equity slices. StepStone itself manages or advises on some $3.4 billion of co-investments, and it maintains a research database of some 385 co-investment deals completed by 96 general partners through 208 funds from 2000 to 2012.

Interestingly, StepStone’s research finds that co-investments have spread from mainly large buyout deals in the mid-2000s to “an even spread of opportunities across the size spectrum, with small and mid-market GPs increasingly seeking out co-investors in a portion of their deals,” according to the presentation. It also finds a broader array of investors participating in co-investments. Whereas banks, insurance companies and wealthy investors dominated co-investing in the early years, today you are much more likely to find in the mix pension funds (California Public Employees’ Retirement System is an example), sovereign wealth funds, family offices, funds of funds and consultants.

A minority of sponsors goes so far as to grant preferential co-investment rights to investors in their fund documents, giving them a first look at chances to put more money to work in deals. According to the Reuters PE/VC Partnership Agreements Study 2014-2015, published by Thomson Reuters, also publisher of Buyouts, about a third of North American buyout funds grant this right, while well over half of international buyout funds do so. One in 10 North American buyout funds offers co-investment rights to all LPs pro rata based on commitments; about 16 percent do so for certain LPs based on the size of their commitment; and about 8 percent do so based on another formula.

With all the focus on LP co-investments it is easy to lose sight that the partners of buyout firms themselves are some of the most prolific co-investors. According to the partnership agreements study, nearly three-quarters (72 percent) of North American buyout funds give the GP the right to co-invest alongside. In such cases, more than two-thirds of the partnership agreements require the GP either to co-invest in all deals or co-invest based on an annual set percentage; in fewer than a third of the funds (32 percent) can the GP cherry-pick which deals to co-invest in.

In fact, about one in five (19 percent) North American buyout and growth equity firms set up co-investment plans for their professionals as an additional benefit of employment, according to the 2013-2014 Holt-MM&K-Thomson Reuters North American PE/VC Compensation Report. Of those, nearly half (47 percent) provide loans to employees to finance the co-investments.

Debate continues over whether co-investments have actually generated consistently strong returns for LPs. But the fact remains that partners at buyout firms consider co-investing to be a perquisite of employment, even when compelled to back every deal.

Surely that suggests that LPs—which get to cherry-pick which deals to do, and which typically pay reduced or no fees—will continue to find these opportunities irresistible.