Co-investment: Toe in the water

Andy Hayes, private equity investment officer at the Oregon State Treasury (OST), is part of a three-person team responsible for the $13.9 billion Oregon Public Employees Retirement Fund has allocated to the asset class, nearly 21% of the total corpus. The co-investment program is run jointly with Washington State Investment Board and management is outsourced.

Contrast that with Teachers' Private Capital (TPC), the PE and direct investment arm of Ontario Teachers' Pension Plan (OTPP). It has deployed C$12 billion ($11 billion) globally - split equally between fund and direct investments - with in-house experts to look at opportunities in different industries and satellite offices (including Hong Kong) to cover different geographies.

TPC favors the proactive co-underwriting deals alongside managers over passive downstream syndication where there is little participation in deep due diligence. OST, by the very nature of its set up, errs more towards the latter end of the spectrum.

It is in this context that the results of Altius Associates' recent study on co-investment programs should be viewed. Relying on a sample of 886 realized US buyout and growth investments made between 1979 and 2010, the study found there is a substantial probability that a co-investment portfolio comprising 10 assets would generate an IRR below 0%.

Deal selection is one of the most important components of driving returns for investors, Dr. William Charlton, Altius' head of US investment, noted. But even with good choices, portfolios may be subject to additional risk because a small number of transactions can move the returns needle substantially - positively or negatively.

The rationale has been explained before. If done correctly, co-investments offer LPs the opportunity to deepen their exposure to certain assets in a fund portfolio without incurring additional fees. But deploying capital in a single transaction rather than across all the deals could also expose the LP to more downside.

One of the primary risks is adverse selection. GPs may not open up the best transactions for co-investment because they want to keep good deals within the fund structure and maximize their carried interest; or they open up potentially bad transactions by stepping beyond their comfort zone in terms of deal size.

LPs that recognize their limitations and either outsource co-investment or build up in-house resources (the OST approach versus the TPC approach) are less likely to get caught out. Industry participants warn that LPs who spread their staff too thinly and often end up being the last people to see deals and the last people to hear what is being said on the ground.

Given Altius' findings are based on deals done in the US only, they may not reflect the fact that the predominantly US-based investor base is not as gung-ho globally as in their home markets.

Marcus Simpson, head of global PE at QIC, estimates there are only 15-20 LPs capable of underwriting co-investments in the manner of TPC. However, he accepts that post-deal syndication is the first step in a journey that may end in a more proactive approach.

According to Bain & Company, LPs participated in only 15% of US buyouts north of $1 billion between 2009 and 2013, typically as a co-underwriter. Canadian Pension Plan Investment Board, GIC Private, OTPP and Temasek Holdings were the most active co-investors.

In Asia as elsewhere, there is increased appetite for co-investment. But beyond a number of very large institutional players there is still more talk than action. Even among the big fish, experience varies hugely, and they will have their successes and failures - in part driven by whether their understanding of the resources required to participate matches the reality.

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• Topics
• Investments
• GPs
• LPs
• Co-investment
• GPs
• LPs
• Oregon Investment Council
• OTPP
• Altius Associates