Co-investing: Why LPs should trust in blind faith

Co-investments are all the rage with limited partners, but are they overthinking?

Co-investment is fast becoming a vital element of a sophisticated, successful private equity programme. It allows limited partners to minimise management fees and put money to work in meaningful quantities; two benefits particularly valued at this point in the cycle.

The data suggest that most LPs are taking an active role in the due diligence process when co-investing, hiring teams of analysts to assess the opportunities that land on their desk. The California Public Employees’ Retirement System (CalPERS), for example, hired Mahboob Hossain a little over a year ago to lead the pension plan’s four-person co-investment team.

CalPERS is far from alone in building its own resource. And why not? Surely it is reasonable to expect those responsible for investing public pension money to undertake due diligence when investing directly into a business. Otherwise they are taking a leap of blind faith, based on the recommendation of a general partner who may – or may not – be incentivised to show them the best of the available deals.

But perhaps that is exactly what they should be doing.

Take the example of Massachusetts Pension Reserves Investment Management Board (MassPRIM). When it set up its co-investment programme about a year ago, it looked carefully at its existing private equity managers and picked the ones with track records of successful co-investments. When presented with a co-investment opportunity by the pre-qualified general partner, it typically approves it as long as it falls within the preapproved parameters.

“We don’t need any lengthy approval process,” says Michael Trotsky, chief investment officer at MassPRIM, in part of a wide-ranging interview with Private Equity International to be published in April. “We’re not second-guessing their analysis and it’s a very quick turnaround. That’s a competitive advantage in co-investments.”

There are clear benefits to following this model. As Trotsky notes, in a market in which co-investment opportunities are highly competitive, it means MassPRIM can move faster on a deal: music to their GPs’ ears. As it doesn’t suck up much internal resource, it is also cheaper, which has an immediate positive impact on net returns.

This approach comes with some caveats. Not having a dedicated team and trusting a GP to bring the most attractive co-investments works best when the LP is familiar with a GP’s track record; it would be a much tougher leap of faith if the relationship were a new one.

Also, by skipping full due diligence on each co-investment, LPs may appear to be throwing money blindly at deals in a market in which selectivity is a key driver of returns. However, one could argue that this is no different to committing to a blind pool fund. It is, in fact, the essence of limited partnership to rely blindly on the GP’s discretion.

The performance of MassPRIM’s private equity programme is literally “best-in-class”: according to a recent study by the Private Equity Growth Capital Council, its 10-year private equity returns outstrip those of a group of 155 peers.

This data would not, of course, take into account its recently established co-investment programme. But with their general partners providing them these returns, can their scheme members blame them for having a little blind faith?

To find out more about PEI's Direct Investor Summit 2016 taking place in Hong Kong on 14-15 April, click HERE.