Investors Are Seeking More Support for Private Equity Co-investments

Art by Bill Mayer

Pension funds are increasingly seeking outside help with their private equity co-investments, looking for partners that can help them build a more diversified co-investment portfolio, see more deals, and react more quickly to opportunities.

Pensions typically invest in private equity funds as a limited partner, paying a management fee of 2% of committed capital plus a 20% “carried interest” fee on higher profits. Co-investments offer limited partners (LPs) the chance to invest in a company alongside a private equity firm, but outside of a traditional fund structure, often with no management fee and no carried interest. While LPs like the fee breaks, private equity firms can use co-investments as a perk for key investors, or to invest in deals that may be outside the scope of their fund’s mandate, such as getting around a provision that limits the percentage of a fund that can be invested in a particular company or industry sector.

Despite those benefits, co-investment discussions are “frustrating, and often fruitless,” according to a June 2019 paper by Hamilton Lane. A majority of private equity general partners (GPs) surveyed by Hamilton Lane said that less than a quarter of LPs that ask for co-investments are actually executing on those opportunities.  

Certainty of capital

Most limited partners, pensions included, don’t have the bandwidth to respond quickly when an opportunity arises, let along evaluate enough deals to build a diversified portfolio of co-investments, according to Richard Hope, a managing director on Hamilton Lane’s global investment team. An LP that can quickly sign off on a deal—or even quickly say “no”—will spare a GP the distraction of trying to scare up extra capital at the same time it is negotiating a co-investment deal, Hope said.  

“GPs want certainty of capital,” Hope said. “In a competitive deal market, GPs want to know who’s with them, and how quickly they can respond.”

Despite the challenges, the value of co-investment deals has more than doubled since 2012, reaching $104 billion in 2017, according to a 2018 report by McKinsey. Hamilton Lane attributes much of that growth to dedicated co-investment funds and more bespoke solutions run by institutional managers.

The South Carolina Investment Commission (SCIC), which manages the state’s $31.3 billion pension, recently signed a deal with Grosvenor Capital Management to manage a bespoke co-investment program, as have other large pensions, like the $75 billion Oregon Public Employees’ Retirement Fund (OPERF). Grosvenor will help SCIC quickly vet the co-investment opportunities that are sourced from its existing private equity partners, while also bringing in new co-investments from Grosvenor’s pool of lower-middle-market PE firms, which had been an area where South Carolina didn’t have much knowledge or exposure.

South Carolina CIO Geoffrey Berg believes that co-investment’s fee breaks will considerably enhance his fund’s PE returns, even after Grosvenor’s fees.

Despite previous forays into co-investment, Berg said that South Carolina couldn’t build a responsible co-investment program alone. SCIC’s previous co-investments were already generating good returns, but they were concentrated into “big, chunky, individual company investments,” which was not a sustainable approach for the pension, Berg said. Concentrating capital into a single company runs the risk that investors could be left holding the bag for a deal gone bad, or caught flat-footed by an unforeseen event like the untimely death of a star founder or executive.

Large, one-off co-investments can concentrate reward as well, like the 10% investment that the California Public Employees’ Retirement System (CalPERS) made in London’s Gatwick Airport nine years ago. That deal turned an initial $155 million investment into a stake worth more than $1.24 billion. But not every investor can access such deals or stomach the idea of placing such a large bet.

“We’re not interested in that, because that would create a single company idiosyncratic risk,” Berg said. “We’re going to build this as a program of small bite sizes.”

Oregon’s pension offered a similar rationale when it announced a $250 million commitment to Pathway Capital Management for an outsourced discretionary co-investment platform. OPERF private equity director Michael Langdon said the new platform would focus on building a diverse portfolio of fee-saving co-investments rather than trying to take a rifle-shot approach to picking the best deals.

You can’t just be opportunistic

“The traditional approach to co-investment really combined trying to save money with also trying to pick the best deals,” Langdon said at OPERF’s January meeting. “Our approach is different.”

As co-investment platforms pick up steam, limited partners have begun to let go of their fears of “adverse selection,” the idea that GPs only offer their less-promising deals up for co-investors.

The specter of adverse selection has dogged co-investment’s reputation for years, but what LPs were really seeing was exactly the kind of concentration risk that South Carolina, Oregon, and their partners are now looking to avoid, according to Jon Levin, president of Grosvenor Capital Management.

“Co-investing, properly done, adds value to a portfolio because you’re simply getting more of the exposures you already like, at 400 or 500 basis points cheaper cost,” Levin said.

The uptick in outsourced co-investment platforms is part of “the next generation of thoughtful portfolio construction,” according to Mark Hoeing, managing director and head of private equity at Commonfund Capital. An earlier wave of co-investment activity, in 2005 to 2007, crashed hard after the Great Financial Crisis, focused more on getting access to in-demand deals, rather than trying to diversify risk, Hoeig said.

“You can’t just be opportunistic in your co-invest platforms,” Hoeig said. “Folks who went hard and early in ’05, ‘06, or ‘07 had outcomes they didn’t desire, because of the vintage year concentration and just being exposed too much to a small number of deals.”

A bit more commoditized

Not all pension funds are entrusting their co-investments to outside partners, and large investors like the Texas Teacher Retirement System and California State Teachers’ Retirement System are hiring in-house co-investment staff. Texas Teachers’ Private Equity Director Eric Lang, speaking at the pension’s July 18-19 meeting, said that additional staff will help Texas Teachers stay one step ahead of less-sophisticated LPs when it comes to accessing co-investment deals and savings.

“The syndicated co-investment world is much more competitive, it’s becoming a bit more commoditized,” Lang said. “So it’s really important that we’re stepping up.”

Not every limited partner has the resources of Texas Teachers, though, and firms like Grosvenor say they are seeing increased demand for their services. To win work, most of them pitch themselves as offering access to a part of the private equity market that clients struggle to effectively reach, like independent sponsors, smaller deals, or international deals.

“Typically speaking, many of our large investors will be able to source large buyout co-investment deal flow on their own, but we’ll find that the co-investment and deal flow we have from our differentiated managers that is complementary to what they’re doing,” Levin said.

For South Carolina, signing up a co-investment partner has already allowed it to see noticeably more deals just within the first six weeks, both from existing partners and potential new relationships.

“There is a tremendous interest in showing us transactions, and we love that,” Berg said. “We’re already seeing a lot of that fruit.”