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The Case For Co-Investments

Summary

Co-investment programs are rapidly increasing in Private Equity.

Multiple studies indicate the co-investment outperform traditional fund investments due to their difference in fee structure.

Many GPs choose to offer co-investment programs to strengthen their relationships with their LPs.

Corporate rollups, emerging markets, corporate carve-outs, and tech-centric/e-commerce business models are current strategies, in which co-investment programs work well.

Analysis

Introduction

Co-investments are minority investments in a particular company or project that institutions invest in as limited partners (LPs) alongside private equity general partners (GPS). Private equity firms may choose to enter into a co-investment with one of their LPs for several reasons. First, co-investments represent an opportunity for GPs to strengthen their relationships with LPs. This is possible due to its difference in fee structure from a traditional private equity fund. In contrast to paying a management fee on committed capital in addition to carry fees, LPs often do not pay fees in co-investment deals. Furthermore, the increased due discretion that LPs have in choosing co-investment deals provides yet another opportunity to encourage partnership. Second, co-investments allow the GP to allocate funds outside legally mandated parameter limits, while delivering outperforming returns. Overall, co-investments represent an attractive prospect for both institutions and GPs.

Co-investments’ are a growing percentage of deal flow due to these benefits. As of 2014, approximately two-thirds of surveyed GPs had co-investment programs, while 42% of these programs had begun within the last five years[1],[2]. Many GPs have changed processes in order to better facilitate co-investment growth.  56% of GPs are shortening their decision-making processes explicitly to augment their co-investment allocations, which typically demand faster selections[3].

Analyzing Performance

Benchmarking against fund investments, there is significant evidence indicating co-investments typically outperform. A 2016 Palico investor survey reveals 90% of co-investments at least match their corresponding fund investments’ performance, while 40% outperform them[4]. This implies that the reduced fee structure is the driving factor of outperformance, as co-investments deliver similar returns to fund investments on a gross basis[5].

While some studies emphasize the benefits of co-investing, others maintain that co-investments underperform in comparison their fund counterparts. For example, a 2014 Journal of Financial Economics paper found that co-investments underperformed due to deliberate adverse selection of co-investments on behalf of the GP[6]. This conclusion is misleading for two reasons. First, careful analysis reveals this study includes an overweight portion of data points across that began in 2006 and 2007, which were particularly negative for private equity deals. A more robust sample both eliminates this bias and concludes co-investments outperform[7]. Second, as co-investments are often used by GPs to strengthen relationships with LPs, it goes against reason to explicitly select investments, which would perform poorly.

Conflicting data points makes it difficult to reach a conclusion. However, these issues disappear when using more robust sample sizes. For example, a 2016 study by
Reiner Braun, Tim Jenkinson, and Christoph Schemmerl at the Private Equity Institute at Oxford University indicates that using a large number of samples from over thirty vintage years eliminates the negative findings. They conclude that co-investments are beneficial for both LPs and GPs.

Due to the reasons outlined in section one, there is clearly a symbiotic relationship between LPs, GPs, and co-investments. LPs derives value from reduced fees, which increases return. Meanwhile the GP benefits both from a reinforced relationship with their LPs and the ability to commit capital to investments, which exceed traditional allocation limits.

Investing Strategies

Timing The Market

Timing the market is not an effect method to generate positive performance in private equity for several reasons. First, private equity investments have a long time horizon. Therefore, it is extremely difficult to accurately predict the market conditions, which would apply to an exit stage valuation. Furthermore, timing the market may cause a firm to spend its capital in a specific timeframe. If unexpected events occur, no capital would be available to capture an opportunity that could be a great value. Overall, it is best to not try to time the market, and instead deploy capital to deals, which will likely provide a positive return in a multitude of market conditions.

Attractive Sectors for Co-Investing

Abbreviated Market Outlook: Currently, we are in the middle of the business cycle and global overnight inter-bank rates remain low. This, coupled with low inflation and positive economic projections from the OECD, suggests continued economic growth in the United States within the next five years[8]. Although high market valuations remain the status quo, there are still spaces, which can still derive a significant amount of value. Below are four promising sectors: corporate rollups, emerging markets, corporate carve-outs, and tech-centric/e-commerce business models.

  • Corporate rollups: Corporate rollups typically involve acquiring smaller companies at discounted multiples, which ultimately seek to reduce operating costs by leveraging economies of scale. Cost reduction sources typically range from product scaling and increased geographic reach. These situations most often materialize during economic downturns or when a market or sector reaches maturity. The most successful corporate rollup deals transact in fragmented industries, which lack a dominant player.
  • Emerging markets: Emerging market investments allow both GPs and LPs to diversify their portfolios away from developed markets to lower overall correlated risk. In these markets, GP’s can leverage both their knowledge and financial access to capture first mover advantages. Additionally, demographic shifts in emerging markets contribute to making them an attractive opportunity. For example, the worldwide middle-class is expected to increase by at least 6% annually through 2030[9]. Furthermore, an average emerging market increase in wages of 2.1% combined with a growing awareness of better standards of living, will likely fuel many sectors, including infrastructure and consumer discretionary[10],[11],[12]. Demographic shifts combined with policy changes provide particular sources of opportunity. For example, recent Indian policy changes such as the simplification of tax codes and restructuring of currency, combined with its changing demographics represents an interesting investment opportunity, particularly in the consumer discretionary sector[13].
  • Disruptive Technologies and E-Commerce Business Models: Companies, which rely on disruptive technologies and e-commerce business models will likely continue to grow in the existing economic climate. Similar to new markets, new technologies provide a significant opportunity to claim market share through first mover advantages.  Furthermore, the continued global shift to e-commerce suggests that this sector will remain attractive for the foreseeable future. For example, the recent investments in Coupang, Chewy, and Alibaba each demonstrate how e-commerce platforms are successful across sectors and markets: while Alibaba and Coupang sell a wide variety of goods within the Asia-Pacific market, Chewy is pet product specialist in North America.
  • Corporate Carve-Outs: In this strategy, a parent company partially divests undermanaged and non-core assets. Once independent, the now standalone business unit can implement the necessary changes to maximize its value. Since these types of investments can often be acquired for smaller multiples, carve-outs are particularly attractive in the current high valuation market. Overall, the lower purchase price, combined with an undermanaged nature, suggests carve-outs are a good source from which to extract value.

Prescriptive Thoughts:

                  As described above, co-investments are equally beneficial for GPs and LPs. They allow GPs to allocate more capital than traditional parameters allow as well as strengthen their relationships with LPs. Meanwhile, co-investments provide higher returns for LPs. Due to these benefits, many GPs are quickly adopting the practice.

As co-investment programs rapidly increase, it remains important to approach co-investments with caution and discipline and not to try to time the market. This uptick in co-investment activity should not lead GPs to diminish due diligence processes in order to evaluate deals faster. Rather, the current high valuation environment demands that investors select opportunities, which generate comparatively higher amounts of value. Corporate rollups, emerging markets, disruptive technologies, e-commerce, and corporate carve-outs are several sectors in which these opportunities still exist.


[1] Duong, Jessica. "The State of Co-Investments." Preqin. March 2014. Accessed July 28, 2017. https://www.preqin.com/docs/newsletters/pe/Preqin_PESL_Mar_14_Co_Investments.pdf.

[2] Palico SAS. "Global Private Equity Compass."

[3] Palico SAS. "Global Private Equity Compass."

[4]  Palico SAS. "Global Private Equity Compass." Palico. Summer 2016. Accessed July 28, 2017. Palico Global Private Equity Compass.

[5] Braun, Reiner, Tim Jenkinson, and Christoph Schemmerl. "Adverse Selection and the Performance of Private Equity Co-Investments." By Reiner Braun, Tim Jenkinson, Christoph Schemmerl :: SSRN. November 19, 2016. Accessed July 28, 2017. Adverse Selection and the Performance of Private Equity Co-Investments by Reiner Braun, Tim Jenkinson, Christoph Schemmerl :: SSRN.

[6] Fang, Lily, Victoria Ivashina, and Josh Lerner. "The Disintermediation of Financial Markets: Direct Investing in Private Equity." Journal of Financial Economics 116, no. 1 (April 2015): 160-78. Accessed July 28, 2017. Redirecting.

[7] Braun et al. "Adverse Selection and the Performance of Private Equity Co-Investments."

[8] OECD. "Developments in Individual OECD and Selected Non-Member Economies." OECD Economic Outlook 2017, no. 1 (2017): 258-62. doi:http://dx.doi.org/10.1787/888933503814.

[9] Kharas, Homi, and The Brookings Institution. "The Unprecented Expansion of the Global Middle Class: An Undate." Global Economy and Development at Brookings, no. 100 (February 2017). doi:https://www.brookings.edu/wp-content/uploads/2017/02/global_20170228_global-middle-class.pdf.

[10] Calculated from data obtained from Korn Ferry for the following emerging market countries as outlined by the MSCI Emerging Market Classification: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, Thailand, Turkey, and the United Arab Emirates (Pakistan, South Africa, South Korea, and Taiwan not included).

[11] MSCI Inc. "Market Classification." MSCI. 2017. Accessed July 28, 2017. Market classification - MSCI.

[12] Korn Ferry Hay Group PayNet. "Wage Increases Slow Globally: Real Wages up 2.3%, as Pay Rises Combine with Low Inflation." Korn Ferry. 2016. Accessed July 28, 2017. http://engage.kornferry.com/Global/FileLib/Salary_Forecast/KFHG_2017_Global_Salary_Forecast.pdf?_ga=2.183254758.1917532193.1501194167-492420828.1501194167+.

[13] Slaughter, Matthew, and Matthew Rees. "Slaughter & Rees Report: India's Tryst with Revolutionary Tax Reform." Tuck School of Business at Dartmouth. July 3, 2017. Accessed July 28, 2017. Slaughter & Rees Report: India's Tryst with Revolutionary Tax Reform.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: This article was originally written for the PEP Group at BlackRock.