Co-investment: Behind the buzzword

When a manager found an interesting deal with a check size his fund couldn't absorb on its own the standard approach was to share pieces of it with his rivals. One moment competing fiercely for a founder's favor, the next they would be working together.

These days there is another option. The manager has LPs willing to provide additional capital. For those institutional players, that may want to deploy more capital, co-investment is an opportunity to do it without paying management fees and carried interest. For the manager, working with sophisticated LPs means additional pairs of eyes scoping out the target, and if a deal works out well he may be viewed more positively when next fundraising.

Co-investment emerged as a buzzword in 2009-2010 and it is growing in popularity, not least in Asia. According to AVCJ Research, the number of co-investment transactions rose from 44 in 2009 to 85 in 2012. Deal value also jumped significantly, from $6.4 billion to $16 billion.

"Co-investment is definitely a trend we are seeing among larger investors," says Mounir Guen, CEO of MVision. "They are looking to be more involved in direct ownership of the companies. They view their relationships with GPs as strategic in nature because they are looking to deploy large amounts of capital outside the kind of portfolio diversification and exposure you have when putting your money purely in funds."

The question is whether this appetite for co-investment is matched by a willingness to put resources on-the-ground so that co-investment opportunities can be responded to quickly and assessed thoroughly.

A local presence

The Canadian pension plans are frequently highlighted as the stand-out examples of LPs that have invested in a local presence in Asia. Canada Pension Plan Investment Board (CPPIB) opened its Hong Kong office in 2008, while Ontario Teachers' Pension Plan (OTTP) launched its office in the city in September.

"We spend a lot of time with our GP partners around the world asking, ‘How can we get better? How do we differentiate Teachers'?" Nicole Musicco, head of externally managed PE and VC fund positions at Teachers' Private Capital, the PE arm of OTPP, told last week's AVCJ Forum in Hong Kong. "The consistent message of what we are doing well is really around the predictability of our investment process."

The idea is that, once GPs are familiar with OTPP's long-term strategy to co-underwrite deals rather than just participate in syndicated co-investments, they will bring opportunities to the fund, recognizing its sectoral expertise. Teachers' Private Capital has 15 professionals, plus six sector-focused teams overseeing areas including financial services, energy and healthcare.

Fund-of-funds occupy a different category, given that many have had teams on the ground for years tracking portfolio GPs. Co-investment has evolved as a complementary function and AlpInvest Partners put a dedicated team in Hong Kong seven years ago. Sander van Maanen, who heads the firm's Hong Kong office, cited establishing a strong local team as the most important component in co-investment.

"I would be scared to do deals in a country where we don't understand the local situation by having teams who speak the local language," he says. "For example, I would not do deals in China if I didn't have a personalized team."

This fear is all the more real for investors whose exposure to Asia is still in its nascent stages. The region might account for 15-20% of a global assets - and PE a fraction of that - so setting up local teams for co-investment just might not be a priority.

When an institution is willing to venture into co-investment, it is likely to start in familiar territory. "If they are just building up their first co-investment team, they might choose Europe and the US where the markets are easier to crack. Asia is really the last step in setting up a co-investment team," van Maanen adds.

A survey conducted by Preqin in June reaffirms this view. Although more than half of the global LPs interviewed expected an increase in their co-investment activity in the next 12 months, most of them preferred North America as a destination, which accounted for 54%. Europe was ranked second, and only 24% of respondents wanted to co-invest in Asia.

Underwrite or syndicate?

Timing is an important factor. While OTPP wants to get involved early as a co-underwriter, the vast majority of LPs are still predominantly back-end syndicators, coming in once a deal is done.

Jim Pittman, vice president in private equity group of the Public Sector Pension Investment Board (PSP), told the AVCJ Forum that of the 15 largest PE deals done between 2006 and 2007, the underwritten co-investments outperformed the syndicated co-investments by a sizeable margin. As such, PSP refined its strategy so that it could commit to deals much earlier.

However, other industry participants argue that returns ultimately won't vary much between the two, and it will take time for LPs to figure out where they sit on the co-investment spectrum and where they want to go.

"It is harder to put capital working in syndicated deals as opportunities are becoming smaller. But it is much harder to execute co-underwriting because it takes a lot of resources and takes much more involvement from the co-investors," AlpInvest's van Maanen adds.

Whatever syndicating or underwriting, LPs must consider what value they offer to portfolio companies in addition to just capital. For GPs that have co-investment opportunities and must identify which LPs to share them with, it is in part a question of whether they can leverage a particular group's networks and reputation.

"Maybe an LP has networks in sectors in certain countries in which your portfolio companies want to expand, get customers, or get regulatory approval," says Eric Chan, managing director in J.P. Morgan's private equity group. "Sometimes LPs might even refer deals to fund in which they have invested. Although it's quite rare, it does happen."

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• Topics
• LPs
• Investments
• GPs
• Asia
• Co-investment
• Direct investment
• AlpInvest Partners N.V.
• OTPP
• JPMorgan Chase & Co