Commonly held wisdom today says mature and maturing LPs will seek robust co-investment, often in the auspices of lowering the fee impact of the asset class.
Of course, not all co-investing is created equal. Various internal and external factors influence whether limited partners can see some or all of the benefits co-investing offers.
Affiliate title Private Equity International recently spoke with California Public Employees’ Retirement System investment director and head of investments, private equity Yup Kim about what it takes to be a successful co-investor, and what LPs should seek to gain from co-investing. The $490 billion state pension is a bellwether LP that often sets the standard for private equity investing.
“I think every LP endeavors to build an in-house co-investment capability,” Kim said. “But as evidenced by many conversations with frustrated GPs, many are not able to execute.”
While the clamor for co-investment does not translate unilaterally into execution ability today, more allocators who historically only invested in funds are arming themselves with tools needed to directly invest via co-investment.
Co-investment opportunities are more bountiful at the the top of a cycle, given that swollen valuations require more broadly-syndicated deals. With rates poised for a hike, that dynamic seems precarious. Port-of-call LPs will enjoy continued access should the deal pool shrink.
Seeking Benefits?
Part of being a port-of-call LP depends on AUM and relationships, but LPs also need to demonstrate the ability to 1) build conviction quickly; 2) ask the right questions; and 3) execute swiftly and effectively. To achieve this, limited partners will need to reach into their pockets to find dedicated co-investment professionals well-versed in the way general partners operate.
In this market, that’s table stakes. Out of such a structure grows specialization and eventually domain expertise, and the ability to act on specific sector and macroeconomic trends.
“Over time, the hope is that not only do you accrue fee savings from co-investments as a lower-cost indexed approach”, Kim said, “but you’re also able to generate real alpha to the overall program returns as a result of focused, proactive company selection.”
LPs need to be proactive about acting on these investment trends, Kim added.
Relationship Value
There is also tremendous value that can be created from co-investment both by the act itself and in a more enduring context.
The action “becomes an active, ongoing series of diligence” that can deepen and strengthen a relationship with the highest-conviction partners, according to Kim. This serves as a reliable window into a GP’s underwriting process outside of the fundraising cycle.
Strong co-investment relationships can also be like an insurance policy against a downturn. Without strong connective tissue between organizations, it will be difficult for GPs to advocate for opportunities during risker times. Investors too timid to deploy into alternatives during the early days of covid and the GFC have largely come to regret it.
For its part, CalPERS has a long-term ambition to make itself more attractive as a partner in co-investment relationships, PEI understands. CalPERS enjoys a wealth of data from various relationships with GPs, which if properly utilized could enhance its partnership value.
The state pension also ducks another potential pitfall for investors in its class: allocation limits. While some endowments can have allocations as high as 40 percent, most pensions are closer to high/mid-teen or single-digit allocations.
Already, the state pension sits roughly 3 percent below its target allocation of 13 percent, and in light of recent secondaries market news from affiliate Secondaries Investor, it could continue to have large sums of capital to deploy.