Andrea Auerbach
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
Yes. At a minimum, investors should consciously consider it. The co-investment “craze” isn’t going away anytime soon—we estimate co-investing currently accounts for nearly one-third of all private investment activity—and there are structural reasons why it will continue, as we will discuss. For investors with allocations to private investments, adding co-investments offers some advantages; namely, lower fees and an ability to directly control capital deployment. We suggest investors take the time to consider this adjacent private investment strategy and whether or not it makes sense for their program.
First, a little history. Co-investing has been available since the first private equity fund was formed and raised, but not always in the form it takes today. It was less prevalent even a decade ago, when managers preferred to invest in each other’s deals (often referred to as consortium investing or colloquially as a “club deal”) and limited partners (LPs) became frustrated paying fees and carry to multiple managers for the same investment. Still, LPs were seeking additional ways to put their own capital to work. We estimate that, in 2007, co-investments represented approximately 5%, maybe 10% of institutional private equity activity. That was then.
This is now—in 2017, our co-investment practice saw $20 billion in US-based opportunities; we believe the total volume of co-investment activity might be double that amount, $40 billion. We estimate that US private equity funds called and put to work an additional $170 billion last year, thus we believe co-investments represented nearly 20% of private investing activity in the United States alone. Not small. Make no mistake about it, co-investing is a substantial private investment activity.
And, co-investing isn’t going away anytime soon. While the median net internal rate of return of global private equity funds declined from 20.2% in 1993 to 10.7% in 2015,* the traditional fund fee structure remained essentially unchanged. Investors are collectively paying the same price for half the return, individual fund performance notwithstanding. Enter co-investing. Managers offer additional access to their investments outside of the fund structure and fund fee structure, often at no fee/no carry. By pursuing those co-investing opportunities, investors can materially reduce their cost of access to the asset class, bringing it more in line with current median private investment returns. Until managers simply reduce the fees and carry on their actual funds to a level more appropriate with today’s median returns, co-investing will continue to be (and should be) on the menu.
So, what to do? One passive approach is for investors to do every co-investment they are offered. Although this will definitely lower the overall cost of access to the asset class, it has some obvious challenges, pitfalls, and risks (such as adverse selection), and is not a guarantee for higher returns. Investors would benefit from a proactive and selective approach rather than an automatic one. Keep in mind that co-investing is essentially one of three control levers available in broad-based institutional private investing: fund commitments, co-investments, and secondary transactions. With co-investments, you can actually time the market by deploying capital at a specific moment—in a private investment context. Compared to making a fund commitment, that is quite an opportunity, and one well worth considering.
* Cambridge Associates LLC Private Investments Database.
Andrea Auerbach, Head of Global Private Investments Research