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Subscribe to insights Subscribe to insights. Sign up to receive invitations Sign up to receive invitations. About our institutional business About our institutional business. Contact us Contact us. Read full report Read full report. Benefits and challenges of co-investing The post-crisis evolution of the private equity industry has seen an increased demand for co-investment capital. Do co-investments pay off? Private equity median net IRRs by vintage year: Co-investment vs. Distribution of capital comparing a traditional GP fund and co-investment fund based on a 2.
Download the full report. GPs are offering more co-invest—a preferred approach over investing alongside other GPs as a consortium—as a way to differentiate themselves with the LP community, deepen relationships with key investors, manage their own risk, and maintain greater investment flexibility for themselves. Make no mistake; despite what some studies have suggested, co-investment returns have the potential to outpace private fund investment returns.
Furthermore, investments by buyout-focused co-investment funds, analyzed on a gross basis to reflect the lighter fee load of direct co-investing, outperformed the net global buyout index in seven out of the ten vintage years examined. Of course, not every individual co-investment outperforms, and therein lies the rub. Implementing a co-investment program is trickier than it may seem at first glance, especially when markets are frothy—as aggregate investor behavior tends to be procyclical.
By leveraging our aggregated data on co-investments and funds generating co-investment, this report frames the opportunities and common pitfalls of co-investing. After briefly reviewing the challenges of analyzing this even more private aspect of private markets we examine the major drivers for co-investing, the key risks, and the practical considerations involved in implementation so that investors can proceed with eyes wide open.
These ways to invest are arranged on a spectrum on the next page reflecting risk-reward and resource competitiveness. Sometimes FOFs charge slightly higher fees on the capital they deploy in co-investments in contrast to their pricing of multi-sponsor co-investment funds than what they charge on their fund investments. At other times, the FOF fee is flat across all types of underlying investments.
While FOFs typically deliver lower losses but fewer outsized wins whether or not they include co-investments , those that charge a flat fee across their investment types have a motivation to include co-investments as a way to negate the FOF fee drag of bps to bps and manage the J-curve, thus creating potential for more alpha. Multi-Sponsor Co-investment Funds Multi-sponsor co-investment funds, typically managed by an advisor, FOF, or similar asset manager with many GP relationships, offer layered co-investment exposure.
LPs invest in a basket of co-investment opportunities that the advisor or FOF sources from its own manager relationships. Despite the lower cost of these multi-sponsor vehicles, investors should be aware that this is primarily a passive, yet direct investment strategy they are using to increase their exposure. These products are ultimately diversified by the number of investments included and by sponsoring GP, reducing the overall risk profile of the co-investment program and potentially the return profile as well.
This approach can also provide participating LPs with an association upon which to build a relationship for access to GPs not in their own programs. The performance of multi-sponsored co-investment funds has been mixed. Of 34 funds analyzed in this report, 25—nearly three-quarters—were performing below the median performance levels of direct funds of the same vintage years and strategies.
Single-Sponsor Co-investment Funds Moving along the spectrum, some GPs raise separate co-investment funds to operate alongside the main fund. Given that GPs may be sensitive about alienating LPs with which they have pre-existing direct co-investment relationships, this type of vehicle may not receive as complete an allocation as expected, as opportunities may also be offered to LPs outside of the vehicle.
Some GP co-invest funds invest in all deals with excess capacity, while others, sometimes in venture, invest only in later rounds of portfolio company financings or in certain types of deals. These single-sponsor vehicles often have a lower fee structure than the core fund, charging fees only on drawn capital, or for administration, or confine themselves to only carried interest to demonstrate some alignment with investors.
LPs committing to annex funds do not make investment decisions on individual transactions. The ultimate basket of extra exposure often comprises a mixture of underperforming and outperforming deals and the diversification itself generally places this approach lower than direct co-investing on the risk-reward spectrum shown on the next page.
They are not obligated to participate or deploy a specified amount of capital, but rather are positioned to see deal flow from sponsors and then make co-investment decisions on a case-by-case basis. With control over investment decisions, LPs can design a co-investment portfolio based on their desired investment characteristics and corresponding return expectations.
Historically, GPs often charged a co-investment fee in these situations, but most managers have been offering traditional direct co-investing on a carry-free and management fee—free basis though administrative costs are involved since the global financial crisis; however, the pendulum is starting to swing back to the traditional model as more LPs pursue, and more managers employ, co-investment. A direct approach affords investors greatest control over the co-investment portfolio created.
Depending on the desired portfolio characteristics, it can offer the highest potential returns. However, it also entails the most risk, as we discuss elsewhere in this report. A comprehensive data set representing direct co-investments, the focus of this report, does not exist, making it difficult to draw conclusions about how these investments have performed universally.
Because co-investments are individual and opportunistic, performance numbers reside within individual investment portfolios. In the absence of centralized and systematically tracked global co-investment data, other studies have generally analyzed one or a few co-investment programs at a time. Going forward, to supplement our analysis of this investment trend, we invite investors or fund managers to confidentially contribute their data to Cambridge Associates for further study.
Our co-investment research methodology uses two different data sets that simulate the behavior of direct co-investors and represent co-investments offered to fund investors. Specifically, we look at the investment-level performance of co-investment funds and fund-of-funds FOFs , two specific groups of LPs that have been particularly active as co-investors, as proxies for professional, institutional investors.
Examining the transactions in which these cohorts invested offers perspective into the opportunities offered to them by GPs and those they chose to pursue. While investors should bear in mind that these FOF LPs are also fund managers themselves, with some motivations that may differ from individual investors, we can still draw some inferences from their patterns of behavior. In this report, we have focused on their gross results—often comparing them to the net results of buyout funds—as an illustration of the co-investments on offer by GPs.
We assume that investors could have participated in these individual transactions versus the investable alternative of traditional private equity funds, and have analyzed their performance accordingly. Following this approach, this report has examined over co-investments done by over 40 co-investment funds and FOF managers. Investors have several good reasons to consider co-investments. For starters, they offer a lower cost of access to private strategies. While in reality there will still be some administrative fees, those costs are lower than management fees paid to fund sponsors.
Avoiding fund-level fees and carry will reduce overall performance drag. Our analysis suggests that individual co-investment outperformance is not just hypothetical, it is, in fact, possible. Figure 1 compares the performance of 1 buyout co-investmentsThis analysis represents buyouts, the strategy in which co-investing is most common.
Hard assets and secondary co-investments were not included, and venture co-investments are addressed separately. As we will show in Figure 6, comparing the gross results for the co-investment funds to the gross results of global buyout funds based on the initial year of investment in a company answers a different question about how co-investments on offer in a given year compared to investments that GPs made themselves in that year.
In practice, with some administrative costs, the fee drag on direct co-investments would place their performance somewhere in the middle of gross and net, but likely closer to the gross results. Using two different metrics—multiple of invested capital MOIC and internal rate of return IRR , co-investments outperformed buyouts in seven of the ten vintage years examined. On an MOIC basis, this outperformance was on average 1. In the three years that co-investments underperformed, the under-performance spread was much tighter at 0.
Figure 1. Companies with an initial investment year after and funds formed after are too young to have produced meaningful returns. Even the most expensive multi-sponsor co-investment funds are typically cheaper than plain vanilla private equity. And when there is little to no fee drag on uncommitted capital, the J-curve the J-shaped dip in performance in the early years when fees and drawdowns exceed distributions from the investment is muted.
Co-investing can concentrate capital normally reserved for diversified fund investments into a single position in a company or a handful of positions in companies, which can be very efficient provided that performance is as expected. The outcome itself is linked only to that one investment or handful of investments rather than a portfolio and therefore may require different risk-reward parameters than those expected from a fund investment, a characteristic that should be understood by all involved.
Institutions pursuing co-investments should accept that diversification is occurring at the private investment program or strategy level rather than the investment level, and that the risk of loss is higher. Without the constraints of a fund, co-investors can focus on specific company attributes, and sectors and regions of interest, among other factors.
They also have more control over pace and can ramp up a portfolio quickly or choose when to stay out of the market, provided they have sufficient access to quality opportunities. Co-investments can also be a way for investors to initiate a relationship with a GP.
Pursuing co-investments seems straightforward: as an LP, you simply 1 tell your GPs that you want to co-invest with them, 2 evaluate the co-investments they show you, and 3 invest in the most compelling ones. However, as anyone who has tried to stand on a surfboard for the first time knows, keeping your balance—i. The expertise required to evaluate and select private investments involves industry and operating knowledge and is different from fund selection expertise.
Investors considering direct co-investments should determine whether they have or would like to add the appropriate skills in-house, work with an advisor, or would prefer to outsource the activity entirely to an advisor or fund manager. If the decision is to pursue co-investment in-house, staff with direct investment experience must be hired with commensurate compensation and performance incentives, adding another layer of complexity and cost to institutional investor teams.
Direct co-investors must regularly remind target GPs of their interest to see sufficient and attractive deal flow. Even then, access can be challenging when many others are competing for the same opportunities. Building strong relationships with GPs for co-investment opportunities can run counter to maintaining appropriate objectivity when evaluating funds, adding another degree of complexity to a private investment program.
GPs may prefer to work with investors they perceive to be savvy about target markets or to have a particular network or industry viewpoint that could prove useful. Finally, some GPs may not offer co-investment opportunities. LPs considering co-investing should be sure to clarify their co-investment rights—as well as the associated economic terms—alongside their fund investments, to ensure they have equitable access to co-investment opportunities.
The potential conflicts around these allocation decisions are moving into the public eye. The timing of co-investments is unpredictable because it is based on deal flow. GPs are likely to syndicate co-investments to their investors when capital accessible via their main funds is low.
This could occur for different reasons and at different points in either the fund-raising or economic cycles. Examples include:. Even if the right professionals are in place and the co-investment pipeline is full, opportunities must often be considered on abbreviated timelines, as described earlier. Once a GP decides to pursue an investment, interested co-investors may have as little as two weeks to review available information, conduct their own assessment of the opportunity, both from an investment and legal perspective, decide whether to participate, and then secure internal approval.
Investors that have not established an evaluation and approval process ahead of time may find themselves gasping for breath when a live opportunity arrives. As an illustration, Figures 2a and 2c compare the performance of two buyout funds against the co-investment funds offered alongside those vehicles.
In both cases, the co-investment funds tracked closely or even above the main vehicles. Disaggregating the investments in the corresponding co-investment funds in Figures 2b and 2d , however, reveals a wide range of outcomes. An investor would have done well only if these co-investment opportunities were offered individually and it picked the right ones.
Figure 2a. Notes: Returns are net of fees, expenses, and carried interest. TVPI is cumulative distributions and current net asset value divided by cumulative paid-in capital. Figure 2b. Notes: Main fund return is net of fees, expenses, and carried interest. Figure 2c. Figure 2d. Even with fund dynamics making co-investments available, investors should be cognizant of adverse selection risk, including the possibility that managers may—knowingly or not—be sharing their less attractive opportunities.
However, GPs often have a good rationale for seeking co-investment capital from LPs:. It is worth remembering that GPs assume significant reputational risk with their investors when offering co-investment opportunities. Poor interactions with LPs and poor results could cost future fund commitments; GPs should have significant disincentives to share investments in which they do not have full confidence. The co-investments as a whole slightly underperformed the main funds, with a 1.
Notes: Chart shows the performance of direct co-investments relative to the 64 funds that sponsored these opportunities. Co-investment data is gross of fees and expenses and sponsor fund investment is net of fees and expenses.
Alternative investments are suitable only for long-term investors willing to forego liquidity and put capital at risk for an indefinite period of time. Alternative investments are typically highly illiquid — there is no secondary market for private funds, and there may be restrictions on redemptions or assigning or otherwise transferring investments into private funds.
Alternative investment funds often engage in leverage and other speculative practices that may increase volatility and risk of loss. Alternative investments typically have higher fees and expenses than other investment vehicles, and such fees and expenses will lower returns achieved by investors. No investment should be made without proper consideration of the risks and advice from your tax, accounting, legal or other advisors as you deem.
This communication is only intended for and will be only distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations. This is prepared for sophisticated investors who are capable of understanding the risks associated with the investments described herein and may not be appropriate for you. The information presented represents how the portfolio management team generally implements its investment process under normal market conditions.
All information provided has been prepared solely for information purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.
There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. A separately managed account may not be appropriate for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing.
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The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management MSIM or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers. Diversification does not protect you against a loss in a particular market; however it allows you to spread that risk across various asset classes.
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