Navigating Co-Investments to Outperformance – Certainly Possible but Hardly a Passive Undertaking
Despite Popularity of “Co-Investing” Alongside Fund Managers, Establishing the Right Evaluation Process and Targeting a Manager’s “Strike Zone” are No Mean Feat
Boston (May 5, 2015) – “Co-investment” strategies, in which investors invest directly into portfolio companies alongside a private equity fund at the invitation of a fund manager, do indeed have the potential to outperform private fund investments. But navigating co-investments toward alpha entails much more than taking a trusted manager up on the invite, according to a new report from institutional investment advisor Cambridge Associates.
The report, Making Waves: The Cresting Co-Investment Opportunity, which analyzed over 500 co-investments and in one exercise, looks at over 100 buyout co-investments and finds that nearly half returned more to investors than the sponsoring manager’s fund. The report also finds that funds that invest in co-investment opportunities outperformed global buyout funds overall in seven out of 10 vintage years.
Investors (limited partners) are attracted to co-investing as a way to increase private investment exposure at a lower cost in order to increase the potential for investment return. And managers (general partners) are motivated by a range of factors to generate co-investment, including the desire to share opportunities with LPs rather than share with competing GPs.
Co-Investing: Harder than It Looks
“Pursuing co-investments seems straightforward: As an LP, you simply tell your GP that you want to co-invest with them, evaluate the deals they present and invest in your favorites. But co-investing is much trickier in practice, and a streamlined and well-developed process for deal evaluation and selection is truly critical,” said report co-author Andrea Auerbach, Managing Director and Global Head of Private Investment Research at Cambridge Associates.
According to the report, the following are imperatives if an institution wishes to navigate a co-investing strategy toward outperformance:
- Make Sure It’s Possible to React Quickly to Opportunities. The timing of co-investments is unpredictable because it is based on deal flow, and LPs sometimes have as little as two weeks to consider an opportunity once a GP presents it. Investors who do not have a streamlined review and approval process ahead of time may find themselves unable to meet GP timelines when an active opportunity arises.
- Go for the GP’s “Strike Zone” – and Avoid Deals that Aren’t in It. The most successful co-investments occur when the deal is in a GP’s “strike zone” – i.e., when the opportunity fits the strategy, size and skill set that a manager is known for. The report looks at 177 co-investments worth almost $3 billion of invested capital – about half of which were in the sponsor’s strike zone – and found a clear difference in performance. Strike zone investments delivered a 1.65 total value on invested capital, while non-strike zone deals delivered a 1.02 multiple.
- Approach Co-Investing with Caution when it’s Particularly Popular, e.g., Today. The best times to co-invest are often during slower markets with less competition; this usually means more favorable valuation environments and less capital competing for deals. Co-investments outperformed buyout funds the most in the early 2000s and 2009, times when overall buyout and co-investment volumes were low compared to other years. Savvy and opportunistic investors may consider holding their fire during periods of high activity, to be ready to co-invest while other LPs are on the sidelines.
- Remember that Return and Risk Potential Vary Depending on the Type of Company. Different types of co-investments perform differently, and LPs should base their return expectations on an understanding of the risk-return profiles of the specific deals they are considering. For example, larger buyout investments tend to exhibit more predictable performance – but they may also result in muted upside compared to other types of co-investments.
- Develop the Right Skills, or Find Someone Who Has Them. The evaluation and selection of specific private co-investments are different from fund selection, and require additional expertise and perspective to incorporate effectively into a program. Institutions looking to co-invest should consider whether they have or could develop these skills in-house, or whether they would like to work with an advisor – or outsource the activity entirely to an advisor or fund manager.
“The bottom line is that co-investing can generate higher returns with lower fees for LPs, but only if they do it right – and that takes perspective, resources, energy, due diligence, and an adequate evaluation and approval process,” said Auerbach.
For a copy of the report, “Making Waves: The Cresting Co-Investment Opportunity,” please visit http://www.cambridgeassociates.com/our-insights/research/making-waves-the-cresting-co-investment-opportunity/. To arrange for a conversation with the author, please contact Frank Lentini, Sommerfield Communications at (212) 255-8386 / Lentini@sommerfield.com.
About Cambridge Associates
Founded in 1973, Cambridge Associates is a provider of independent investment advice and research to institutional investors and private clients worldwide. Today the firm serves over 1,000 global investors and delivers a range of services, including investment advisory, outsourced investment solutions, research and tools (Research Navigator and Benchmark Calculator), and performance monitoring, across asset classes. Cambridge Associates has more than 1,100 employees serving its client base globally and maintains offices in Arlington, VA; Boston; Dallas; Menlo Park, CA; London; Singapore; Sydney; and Beijing. Cambridge Associates consists of five global investment consulting affiliates that are all under common ownership and control. For more information about Cambridge Associates, please visit www.cambridgeassociates.com.
This press release is provided for informational purposes only and is not intended to be investment advice. Any references to specific investments are for illustrative purposes only. The information herein does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. This release is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. Past performance is not a guarantee of future returns.
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