Friday Letter: Teaming up sensibly

Co-investment doesn’t have to be bad for private equity, as long as both GPs and LPs take a thoughtful approach

It is no secret that at the moment, LPs have a large appetite for co-investment. Whether it is to reduce their costs, mitigate the J-curve and/or gain more control over the risk profile of their investment portfolios, the majority of LPs are keen on getting some co-investment action, GPs on the fundraising trail tell us. A quick look at the number of co-investment funds raised in recent years tells us that the trend is here to stay for the foreseeable future.

So with co-investment being the word on everyone’s lips, it was perhaps surprising to hear Tim Jones, chief executive officer and deputy chief investment officer at Coller Capital, telling delegates at the EVCA Investment Forum in Geneva this week, that in his view, co-investment is not doing the industry any good.

“The whole co-investment trend is a bad trend,” he said. “More LPs are pushing GPs for co-investments and for co-investment rights sometimes. It is forcing the GP to do bigger deals than their normal strategy deals.” By satisfying LPs' hunger for co-investments, GPs may be increasing their financial firepower by up to 25 percent or so, he suggested. “[Saying] 'give me some of your overspill' is putting pressure on the GPs to do deals they really shouldn't be doing.”

What’s more, the co-investment dynamic – as well as LPs going direct – is increasing competition and pushing up prices, the conference heard. “Of course it is cheaper for [LPs] to invest [directly] just because they are not paying carry now. In reality they are paying higher prices [for assets],” Ralf Huep, general manager at Advent International, told delegates. “They are not as educated as we are and will make some mistakes in the years to come.”

In reality, however, many LPs are unequipped to set up a co-investment programme, let alone have the capabilities to cut out the middle man completely. Even for sophisticated LPs, setting up a direct or co-investment team is expensive, and also raises governance and risk management issues that for some institutions will just be too big to overcome.

As a result, GPs say that when certain LPs ask for co-investments, both sides know that when such opportunities arise, the offer won’t be taken up. The few LPs that are really geared up to co-invest will know that GPs aren’t going to jeopardize the performance of the fund just to give them their preferred co-investments. Perhaps this is why GPs try to formulate the co-investment strategy as loosely as possible, so they are not under any obligations to do deals that are bigger than they are comfortable with.

And although there are a few Canadian pension plans and a handful of sovereign wealth funds that have successfully bypassed private equity houses, end investors that compete directly with the GPs are still only a small minority. Managers therefore don’t often bump into them when they source their deals, the conference heard from Joseph Schull, managing director and head of Europe at Warburg Pincus. “We are backing growth businesses in the middle market and [do] complex carve-out transactions. That tends not to be where the sovereign wealth funds and others are doing direct investments today.”

What’s more, many LPs that are active on the co-investment front – like Dutch pension fund PGGM – don’t have a desire to cut out the GP altogether. “We are building out our co-investment programme but we will definitely be partnering with GPs. We are not going to build our own GP… We won't become another Warburg Pincus,” said PGGM’s head of private equity, Eric-Jan Vink.

All told, co-investment can be a welcome trend that benefits the industry. Just as long as GPs offer co-investments only when they genuinely need more firepower, and LPs only accept the opportunity when they have the skillset and the team to deliver on it.