How co-investments continue to evolve

General partners and investors alike are driving changes in how capital for the strategy is being structured and raised, and how opportunities are being accessed.

As demand for co-investment opportunities increases, managers and investors are rethinking their approaches to both product and strategy, according to speakers on an innovative capitalization structures panel at the PERE America conference.

“To say that the co-investment business has scaled is an understatement,” one speaker said. “It’s massive. It’s like its own industry, given the underlying economics.”

A second panelist observed that a number of investment managers are trying co-investments for the first time. Co-investments have generally been common among smaller managers that started as operators and have a history of syndicating or finding capital partners on a deal-by-deal basis. The more recent trend, however, is the number of large managers pursuing co-investments, the panelist said. There are now numerous nimble and reliable investors – and creating dedicated pools of capital for co-investments is becoming more common, making the process easier.

Another trend is the formation of sidecar vehicles to raise and invest co-investment capital more quickly, a third panelist said. Instead of handling co-investments on a deal-by-deal basis – where the general partner has to seek out LPs for capital – many GPs are streamlining the process by electing to create sidecar vehicles for co-investments where terms would be pre-negotiated. While investors would still have to sign off on each deal, the advantages are that they would not be scrambling to gather documents and would not have to go back to an investment committee, since an allocation has already been made to the vehicle, he said.

As co-investments become more common, pre-negotiating the terms may prove to be a challenge for managers and investors alike. When real estate investment managers approach co-investment vehicles, they need to think about being responsive to the investors asking for co-investment rights while making sure the economics of the co-investment vehicle work for the GP, the third panelist warned. GPs will need to decide whether they can agree on a blended management fee rate in exchange for future investment flexibility, he said.

Meanwhile, managers are also reevaluating how some investors take part in co-investments. A manager may agree to let investors commit to a co-investment opportunity without taking part in the main fund, according to a fourth panelist. His own firm brought on third-party investors for co-investments based on their unique capabilities to help grow a particular platform, he said. However, because of the increasing demand for co-investments and the fact that such opportunities are “too valuable” to offer to investors without receiving a fund commitment in exchange, he believes there will be a trend toward limiting co-investment opportunities to investors in the primary vehicle. The one exception would be an investor that possesses a unique attribute that can help execute on an investment plan, he said.

Some LPs will commit a small amount of capital to the primary fund in order to make larger co-investments, according to the second speaker. However, some larger investors will counter this behavior by requesting LPs first meet a minimum percentage of the investor capital base before gaining access to any co-investments, he said. This can sometimes put real estate investment managers in a tough spot when looking to close on a deal because not all of the large LPs can move swiftly, and the smaller investors will be blocked from the deal, he explained.

While co-investments often offer lower fees and more direct real estate exposure for an LP, they also present the risk of economic misalignment and adverse selection.

“If I were advising LPs, I’d be very careful of doing co-investments at any scale because there’s a good chance that there ends up being some economic misalignment,” said the fourth panelist.

Typically, the GPs do not put in any additional capital to the co-investment, so they are basically getting double leverage on carried interest from the fund investments and the uncrossed pieces in the co-investment, he explained.

He warned that some investors may not be doing their due diligence because they think they are benefitting from the lower fees and lower J-curve impact. These investors tend to get adversely selected into the worst investments in the fund – the riskiest deals with the lowest potential returns – he said.

Speakers on the panel included StepStone Real Estate director Alex Abrams; Andrew Jacobs, managing director of Metropolitan Real Estate, the indirect real estate arm of The Carlyle Group; Philip Mintz, chief investment officer for US and Asia at Apollo Global Management; and Joshua Sternoff, corporate partner in the private investment funds practice at law firm Paul Hastings.