The attraction of co-investment funds

Co-investment is an investment style in private markets which consists for a fund to acquire a minority investment in companies, alongside lead General Partners (GP). It differs from a traditional private equity (PE) fund as it does not take a controlling stake and therefore the fund does not intend to influence a business’ strategy.

As co-investment funds can invest in just one company within a portfolio of companies a specific sponsor holds, it gives the opportunity to invest across a spectrum of strategies, sectors and countries with more flexibility than a more specialised PE fund might.

According to McKinsey, the value of co-investment deals more than doubled between 2012 and 2017, reaching $104bn in 2017. Why has the demand for co-investment grown so much and what are the benefits of this strategy?

Diversification at all levels

Multi-sponsor co-investment funds provide a potentially strong diversification benefit. Contrary to a traditional PE fund, the investment is not deployed along a specific strategy or geography. The investment universe could be as wide as wanted.

The portfolio of companies can be built investing alongside different lead managers and in different strategies, vintages and geographies. Due to this characteristic, a co-investment fund provides diversification in a private market investments programme in a much easier and faster way than allocating to different strategies over time.

It also gives more flexibility in selecting attractive investments as the universe considered is much larger than for traditional funds. And as the fund can be invested in companies at different levels of development, there is the potential to reduce the effective of the so-called J-curve, or the tendency to produce negative returns in the early years of the fund before positive returns kick in as investments mature.

An enhanced investment process

The lower risk from the diversification process is also compounded thanks to an enhanced investment process. Co-investment funds have the opportunity to invest alongside several lead sponsor, which mitigates the risk of one sponsor due diligence being inadequate. Additionally, co-investment funds run their own due-diligence on any company they consider investing in, on top of the initial due-diligence the main sponsor carried before including the company in its portfolio.

Lower fees than usual

All those positive factors are usually delivered at a lower fee than a traditional PE fund would consider. The main sponsor typically does not charge fees to co-investment funds investing alongside them. And as co-investment funds only take minority ownership in companies, the management fee and the carried interest are usually lower than for a traditional fund. As such, average net returns tend to be attractive compared to traditional PE funds.

The diversification advantage, enhanced investment process and more attractive net returns are the main reasons behind the success of co-investment strategies.

Fund selection is paramount

The above fee advantage also highlights the challenges facing investors when choosing co-investment funds. It is a more passive strategy as funds only take a minority stake and do not actively manage the companies they invest in. Finding the right company to invest in alongside a respectable main sponsor is key. And the risk of adverse selection when investing in companies is real — though a recent academic study from researchers at the Technische Universitat Munchen and University of Oxford shows that it might be overstated.

For those reasons, choosing well-established co-investment funds with strong links in the industry would likely reduce the risk of such challenges. It would also likely offer better opportunities from lead sponsors, as most of those arise from existing relationships between two funds.

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