Not merely satisfied with having access to private equity funds, some investors are increasingly partnering with General Partners (GPs) to invest directly alongside them in individual deals.
Private equity co-investments allow investors to back individual deals alongside managers, rather than investing in 10-year blind pool private equity funds. Interest in this type of investment has skyrocketed in recent years. An analysis of PitchBook data by law firm Troutman Pepper shows that fundraising for co-investment-focused funds has more than quadrupled over the last decade, climbing from US$5 billion in 2010 to more than US$20 billion in 2021.¹ Figures for co-investment transaction volumes and values are more difficult to source, but research published by consultancy McKinsey in 2018 showed that co-investment deal value more than doubled to US$104 billion since 2012.²
The growth in co-investments has opened up new avenues for investors to construct their private portfolios and build out exposure to the asset class. Investors can access co-investment opportunities in different ways too, allowing for additional optionality in portfolio construction. Single co-investments are offered to existing investors in private equity funds to double down on individual deals. There is also the option to invest in a specialized closed-ended co-investment fund that invests alongside top-tier fund managers that have shown a proven track record.
Co-investments give investors the opportunity to make minority investments in individual companies alongside private equity managers. Private equity firms will invite their investors to back specific, hand-picked deals, allowing investors to have visibility on what they will be investing in, and the discretion to accept or decline as they require. This is unlike investing in traditional, 10-year private equity fund structures which are blind-pool vehicles where a manager raises money from investors against a specific investment strategy. Investors do not know what companies the private equity firm will acquire through the life of the fund.
The product has gained in popularity for several reasons, but arguably the biggest appeal for investors has been the attractive economics of co-investments. Unlike private equity funds, which typically charge a management fee of 2% and carried interest of 20%, single co-investment deals will typically be offered without incurring any management fee or carried interest charges at all. Investments made via co-investment funds are typically charged a 1% fee and 10% carried interest.
Favorable economics aside, co-investing also gives investors more flexibility and control over their private equity portfolios. Investors with specific geographical or sector insight, for instance, can leverage their knowledge by choosing co-investment deals that map onto their expertise. In a fundraising market where blue-chip managers regularly have to cap allocations to their primary funds to accommodate demand, co-investing gives investors scope to increase their exposure to top-tier managers by investing alongside them on individual deals.
Investors who are still building out their private equity allocations also benefit from co-investing as it helps to accelerate deployment into the asset class. For instance, doing due diligence on a relatively illiquid 10-year blind-pool fund for the first time takes a significant amount of resources.
In a co-investment scenario, however, an investor can deploy additional capital on top of a primary fund commitment, with a manager that has already been vetted. Investing in a deal alongside a manager you have already backed, and are familiar with, is more streamlined than starting a manager due diligence exercise from scratch. The value of the insight that co-investing offers into how a fund manager sources and executes deals should not be underestimated, either.
Finally, co-investments have proven particularly relevant during and after periods of macroeconomic and geopolitical volatility.³ When there is little visibility in markets, making a long-term commitment to a 10-year fund can be daunting. Co-investing allows investors to continue deploying money into the asset class while providing the flexibility to temper the pace of deployment in line with risk appetite.
Co-investments have also been shown to potentially deliver outperformance over time. A 2016 study by academics Reiner Braun, Tim Jenkinson and Christoph Schemmerl, for example, suggests that well diversified portfolios of ten or more co-investments outperform fund returns.⁴ In addition, BlackRock’s analysis of Preqin’s performance data shows that co-investment funds outperform direct private equity funds in nine out of ten recent vintage years based on the median net IRR.⁵
As with any investment, co-investing comes with certain risks and investors stand to lose all capital invested. In a healthy portfolio, co-investments should only comprise a small percentage of the overall portfolio. Inadvertent adverse selection is a possibility - it is impossible to tell in advance what will be the quality of the deals that come forward for co-investment. Co-investment also requires investment in teams with the experience to assess deals on an individual basis. LPs need to make quick decisions, which require resources and experience.
Investors who go in with their eyes open, however, can mitigate these risks to some degree. Adverse selection, for example, is less likely with reputable private equity managers who are inclined to offer the pick of their deal flow up for co-invest, given the importance of nurturing long-term investor relationships. It is important to remember however, that even for managers with strong track records, past performance is not indicative of how future investments might perform.
Investors also have the opportunity to undertake their own due diligence, adding an additional layer of scrutiny to investment decisions; and even in a scenario where a co-investment deal ends up underperforming the multiple on invested capital (MOIC) of a fund as a whole, the lower fees and carry on co-investment can still see an investor come away with net returns that are on par (or even better) than overall fund performance.
The Moonfare platform has built up extensive experience sourcing, executing, and managing co-investment deals. The firm has a team of 10 investment professionals with extensive co-investing experience and a pool of more than 250 active GP relationships.
This scale has given the team the resource and insight to screen the market for the best opportunities, secure quality co-invest deal flow, conduct effective due diligence and execute on the selected deals.
The firm undertakes its own due diligence, works through all GP due diligence and can close a co-investment deal within four to five weeks. Moonfare’s capability, and the team’s experience, has enabled Moonfare to land co-investments with some of the industry’s best managers. Highlights include deals alongside top-quartile managers Insight Partners and Cinven to acquire data aggregation and analytics platform Inovalon and wealth manager True Potential respectively.
Embarking on co-investments does require careful thought and preparation, but every investor in private equity should be considering it given the attractive economics, diversification, and flexibility it offers.
This content is for informational purposes only. Moonfare does not provide investment advice. You should not construe any information or other material provided as legal, tax, investment, financial, or other advice. If you are unsure about anything, you should seek financial advice from an authorised advisor. Past performance is not a reliable guide to future returns. Your capital is at risk.
¹ Troutman 2022. The Co-Investment Landscape Review: Breaking Down Key Trends Shaping Co-investment Activity
² McKinsey 2018. The rise and rise of private markets
³ Capital Dynamics 2021. Private Equity Co-investments: Post-crisis performance
⁴ Braun R., Jenkinson T., Schemmerl C. 2016. Adverse Selection and the Performance of Private Equity Co-Investments
⁵ Blackrock 2021. The Advantages ofCo-Investments
* Past performance is no guarantee of future returns.