(April 1, 2014) — Investors tempted by co-investment deals in private equity assets should watch out for concentration risk and poor returns, according to Altius Associates.
Co-investment deals see investors buying a direct stake in a company alongside a private equity fund. They have become popular with institutional investors in recent years, due to the advantages they offer, including: avoiding annual management fees; capturing the full upside by not paying carry; the mitigation of the ‘J’ curve phenomena; immediate deployment of capital; and control of investment/sector exposure.
For those selling the co-investment deals, the partnerships provide a way for buyout firms to raise capital. Firms including BC Partners, EQT Partners, Cinven, and Permira have all offered fee discounts to investors that take part in a first close.
Some of the world’s best known private equity investors—including PGGM, F&C Investments, Abu Dhabi Investment Authority, Partners Group, AlpInvest Partners, Pantheon, and Hermes GPE—are known advocates of co-investments.
And last year, the London Pensions Fund Authority completed its first ever private equity co-investment, teaming up with Swiss private equity manager Adveq to buy a stake in postal company Secured Mail.
However, a study carried out by Altius that analysed 886 realised US buyout and growth investments—ranging from 1979 to 2010—showed that for a co-investment portfolio made up of 10 assets there was a substantial probability that the entire portfolio would generate an internal rate of return (IRR) of less than 0%.
Even with a 20-company co-investment portfolio, it was possible to lose significant capital as measured by either IRR or multiples.
Author of the study and Head of Americas Investment at Altius Dr William Charlton said: “As with most aspects of private equity, selectivity is one of the most important components of driving returns for investors. But even with good choices, co-investment portfolios may be subject to additional risk due to the impact, positively or negatively, of a small number of transactions in the portfolio.”
Altius’s research revealed two inherent risks. For general partners (who retain management control, share the right to use partnership property, share the profits of the partnered firm, and have joint liability for the debts of the partnership), there may be an incentive to keep the highest expected return investments wholly within the fund structure.
But adverse selection may occur when funds offer co-investment in deals that exceed fund capacity, which may put the fund manager in a market segment for which past returns are not representative and are more uncertain.
For limited partnerships, (where partners have limited liability, no management authority and are only liable on debts incurred by the firm to the extent of their registered investment,) Altius identified substantial concentration risk. Limited partners tend to only invest in a subset of a manager’s portfolio, leading to an over-concentration of investment in a small number of companies, it said.
“While there may be important strategic reasons for institutional investors to establish or expand co-investment programmes, care should be exercised to avoid the issues of intentional or unintentional adverse selection,” Charlton continued.
“Even if adverse selection can be avoided, there should be an appreciation for the nature of the risk inherent in a portfolio that contains a small number of risky investments that are likely to be highly correlated.”
Despite the risks, it seems investors’ appetite for co-investment private equity deals is on the rise. Data from Preqin released last month showed half of the private equity investors it questioned were planning to increase their exposure to this type of deal in 2014.
Today, 40% of investors Preqin spoke to are actively co-investing, while 37% are co-investing on an opportunistic basis. Another 16% are considering co-investing in the future.
However, in direct contrast to Altius’ expectations, 77% of investors expected their co-investments to outperform their fund investments by 2.6% or more, while no investors expect them to perform the same or worse.
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