Co-investment: Friends with benefits

Ask any GP about their past experiences of co-investment and you are not necessarily going to get the same answer from all. Such transactions are by no means new to the asset class but the understanding of what they involve and what investors expect from them is changing.

"When I was asked to participate in a co-investment panel, intuitively it implied to me investing alongside other GPs," said George Raffini, chairman of Headland Capital Partners, speaking on a panel at the AVCJ Forum. "If you look at our history about 30-40% of all deals have been co-investments but only about 5% of those have been with LPs in our funds."

Yet, in the last few years there has been a rise in the number of GP-LP co-investments. This is in part a response to the post-global financial crisis fundraising environment.

Institutional investors are looking to consolidate their fund manager relationships, which means GPs must offer more to secure a re-up. Co-investment is a classic sweetener, offering LPs the opportunity to reduce fees and generate higher returns, and also to develop closer relationships with GPs.

According to Preqin, funds-of-funds are the LPs with the biggest appetite for these kinds of deals, accounting for 23% of co-investors globally. Public pension funds make up 10% with asset managers, private sector pension funds, insurance companies and banks accounting for 7%. By region, 25% of LPs that co-invest are in Asia, 44% are in the US and 31% are in Europe.

AVCJ research meanwhile reveals a broader trend in Asia favoring co-investment deals in general: the number of transactions between 2009 and 2011 rose by more than 50% to 535.

Helpful partners?

It is, however, not a zero-sum game: GPs may need extra capacity to target certain transactions. "The most obvious reason to seek co-investors is when a deal is too large." said K.Y. Tang, chairman and managing partner of Affinity Equity Partners, and another panelist. "In the early days we always went to other GPs but once we changed our minds, our first preference became LPs."

According to Tang, when Affinity was raising its first fund, LPs on the whole were unfamiliar with co-investment deals and only four parties showed any interest. When the GP was raising its most recent fund in 2006, however, as many as 45 LPs expressed a desire to co-invest.

"One of the nice things about Asia, in many respects, is that it's really well set up for co-investment," says Doug Coulter, a partner with LGT Capital Partners. "Track records are still being established, brands are still being built, even by some of the bigger GPs. If you have some strong LPs, why not build the relationship? If it is such a good deal you might not want to show it to a competing GP."

The decision to co-invest with another GP may be born out of a need for the expertise that a particular manager can bring to a deal, such as an understanding of the regulatory environment in a specific industry or country, or because they have access to a certain market. Headland's Raffini argues that co-investment with LPs should be motivated by similar considerations.

"There is no template, but that should be the driver of co-investments rather than fee reduction from a LP point of view or getting to know a LP because of upcoming fundraising, and I largely think that has been the case," he said.

Furthermore, not all LPs are suited to co-investment. One Asian GP, whose firm recently made its first co-investment, noted that only larger, more experienced LPs are able to make decisions quickly.

"When we offer a co-investment opportunity to our LPs they are under a very specific time frame to respond; if they don't respond in time then the chance is gone," the GP says. "Many LPs are used to taking their time. You can email one and not get a response for two weeks, which on a deal timetable is forever. They are supposed to get back to you in two hours not two weeks."

Big picture

Nevertheless, a need to encourage quality LPs to re-up means GPs are still willing to extend co-investment invitations and becoming more aware of institutional sophistication in area.

Pacific Equity Partners announced this week that it would seek to raise A$3.5 billion ($3.6 billion) for its fourth fund, with A$2 billion of core equity plus a further A$1-1.5 billion earmarked for a discretionary co-investment pool. The GP's previous vehicle featured A$2.7 billion of core equity plus A$1.3 billion in co-investment capital, structured on a discretionary basis - the co-investment was packaged into the fund and there was a single decision-making entity.

The idea is that the more modest fund size will pursue the same kind of deals but over a shorter deployment period.

LGT's Coulter points to a broader trend: even the more successful GPs are struggling to raise capital, either by choice or by design because that is what the market. "On the other hand Asian economies are growing and the average check size is increasing," he adds. "One would expect more co-investment opportunities with smaller funds and larger equity checks. In general, it is a good time for co-investment."

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• Topics
• LPs
• GPs
• Co-investment
• Headland Capital Partners
• Affinity Equity Partners
• LGT Capital Partners
• Pacific Equity Partners
• Asia
• Direct investment