A desire among investors to be closer to the action, to have more of a say in where their money is invested and for greater agility around investment decisions has led to the rapid emergence of co-investment. And that could offer something for everyone
Picture the scene. You enter a casino and, on arrival, hand over your betting money to a manager, who puts it in with everyone else’s. At the end of the evening, he gives you back your (much smaller) share of the proceeds, with little indication of which particular one-armed bandits and roulette wheels your money has disappeared into.
Doesn’t sound like much fun, does it? But that’s pretty much what investors do when they put money into a private equity fund – the obvious difference being that when the fund eventually winds up, they expect to have made a considerable profit rather than a loss.
How much more interesting, though, would it be if you had been able to choose where at least some of your money went, and to directly buy shares in companies you liked the look of?
Co-investment offers precisely that element of direct exposure to shares of privately held companies. As a result, it holds a strong appeal for investors of all sizes and levels of sophistication and has become increasingly popular over the past decade.
Research by Preqin in November 2019 – the Preqin Investor Outlook: Alternative Assets H1 2020 – showed that the proportion of limited partners expecting to make co-investments in the next 12 months was 37% – up from 35% a year earlier.
And as businesses look for extra capital in the wake of the Covid pandemic, those numbers could rise further.
Co-investment can take different forms. In its most common form, private equity funds offer their bigger investors the opportunity to take direct stakes in some of their deals, alongside the fund’s own investment.
Alex Henderson, a Senior Associate at Mourant in Jersey, explains why they are willing to do this.
“First, some funds have concentration limits,” he says. “The fund documents might say you can’t invest more than 10% of the fund in a single portfolio company. The manager finds a great deal they really like but it accounts for 13% of the fund.
“At that point, they still want to make the acquisition but they decide they’ll put 10% through the fund, and find co-investors for the other 3%.”
A second reason, he says, might be because the fund manager wants to bring in a strategic investor who can help with that particular portfolio company because of their expertise.
Meanwhile, a third reason may just be a case of trying to build a relationship with an investor the fund manager wants on board.
“For a relatively new manager,” says Henderson, “perhaps with a limited track record, offering attractive co-investment opportunities can be a great way to develop a relationship and showcase the manager’s ability to a key target investor – ultimately with a view to securing a larger investment from that investor in the manager’s next fund.”
Performance drive
One of the key reasons big institutional investors are attracted to co-investments is that they often get better performance than in the fund itself, says Kees Jager, Head of Funds at Intertrust in Guernsey.
The reason for that is simple. “The usual fund structure is that you’re paying 20% carried interest – the manager’s commission on profits – and up to 2% management fees,” says Jager.
“Through co-investment, deals are sometimes offered for free, depending on the relationship between the manager and the investor. In any case, they are usually lower than via the fund structure.”
Institutional investors also relish the opportunity to have direct exposure to the company, understanding how it operates and its view of the market, and in some cases putting someone on the board.
Often, these investments are structured through a special-purpose vehicle into which each of the investors making co-investment invests. But Jager says a relatively recent innovation has seen some investors taking an alternative approach.
“What we have seen in the past 12 to 18 months – and I think it is continuing despite Covid-19 – is that some limited partners are setting up their own structures,” he explains.
“It is still a GP/LP structure, and the manager still controls the GP so the fund maintains the control. But for the investor, it means they can be nimbler when deal opportunities arise.
“It’s a more efficient way and it takes out some of the cost. We are doing more and more of these at the moment.”
Intertrust has a track record of administering and helping investors to create these standalone structures, Jager points out.
Co-investment is usually offered by private equity funds on the way in, at the time when the fund manager is sourcing deals, and the terms would be broadly the same as those the fund itself has negotiated. Capital raised by the investee company is typically needed to fund the next stage of its growth.
However, the pandemic is seeing a variation on this, as some companies are already seeking extra capital because their cash reserves have been depleted by the impact of lockdown and the subsequent economic downturn.
“At the moment, those capital needs are generally specific to the portfolio company,” says Henderson. “For example, a company in the retail sector that has been forced to close and needs cash to resume operations.”
In some cases, co-investment may be offered in the form of preferred equity, where investors get their return first, with fixed upside. However, there is no limit on the downside – they can still lose their money in the same way as a traditional equity investment.
In the next six to 12 months, as managers fully assess the effects of the pandemic on their portfolios as a whole, Henderson predicts that we will see an increase in restructurings coordinated by fund managers.
For example, there may be an increase in continuation vehicles – where a fund that is due to wind up has valuable assets that it doesn’t want to dispose of too cheaply given the market conditions.
Fund managers may seek to transfer these assets into a longer-term vehicle, which may also raise additional capital to support the next phase of growth for the portfolio companies – presenting another set of co-investment-type opportunities for investors.
Smaller investors such as wealthy individuals and family offices, which don’t have the same financial clout as the big institutions, would struggle to get access to the co-investment deals offered by fund managers – but that doesn’t mean they don’t also have an appetite for taking direct stakes in private companies.
Aidan O’Flanagan, Head of Funds at Highvern in Jersey, says: “These investors are becoming increasingly sophisticated, and more and more they are attracted by the ability to invest directly.
“But direct investing is expensive, it’s difficult to scale, and access to institutional investment opportunities is unlikely unless they have a substantial portfolio and in-house investment team, and annually can commit large amounts to deals.”
Pooling resources
However, there is a solution at hand, says O’Flanagan. Specialised co-investment managers are bridging the gap by bringing together a number of these smaller investors to pool their resources outside any fund structure.
He explains: “These deal-by-deal managers will sign up 20 investors, for example, and they can bring deals and ask if you are interested.
“If you are, they’ll have a vehicle just to co-invest into that one deal, alongside the lead investor, which could be a fund.” It’s like a fund but not, adds O’Flanagan.
From an implementation point of view, he says, each deal vehicle can be built using a copy-and-paste approach, drawing on the same Know Your Client data and limited partnership agreement – in the latter case with slight adjustments.
“It’s very quick to market; we can set one up within a week, and it’s not regulated like a fund,” O’Flanagan points out.
A back-office technological benefit is that each investor is given exclusive access to their own investor portal showing only the deals into which they’ve invested – all their holdings, calls, distributions and documentation.
Looking forward, O’Flanagan believes some of the managers doing this may decide to become funds, because of the advantages in terms of the fees that can be charged and the ability to secure all the investment at the outset.
In any case, the demand from smaller investors isn’t going to disappear, so new managers are likely to come in to take their place.
Whatever form it takes, co-investment has become an established part of the private equity landscape and is likely to continue to grow in popularity as investors seek to maximise the value they get out of their relationships with fund managers.
Henderson notes that some managers are already establishing dedicated vehicles for co-investments alongside their main fund vehicles right from the outset – and seeking to charge fees to those participating in those opportunities.
Everyone, it seems, wants to be part of the deal.