Co-investments don't make sense because the process is too time-consuming, the head of an Asia private equity fund says.
The whole process of soliciting capital commitments from investors can mean that the fast and nimble footwork needed to secure a deal can be impossible in a co-investment structure.
And as more investors move into the popular PE market, returns on co-investment deals are not currently seen as attractive.
Traditionally, co-investing has referred to a limited partner in a PE fund investing alongside the fund manager or general partner (GP). But co-investments have recently been seen in more forms - from fund-of-fund managers including direct co-investments in their mandates to GPs raising separate co-investment funds alongside their main fund.
At present, there is a great deal of competition and “no bargains out there,” said Kyle Shaw, managing director of Shaw Kwei & Partners. “We need to pay a relatively high price for investing today,” he said. Shaw Kwei is presently investing from its $450 million third pan-Asia fund.
"I don’t think that makes sense," said Shaw, referring to co-investment. “We make decisions very quickly - we don’t have the time to go around and solicit commitments.”
Co-investments have grown in popularity with institutional investors in recent years as limited partners (LPs) seek to invest more with select GPs at a lower cost, according to a report released this month by investment consultancy Cambridge Associates (CA).
Now may not be the best time to pursue co-investments, however, according to CA. Their analysis found that better returns on co-investments had been achieved when GPs sought additional funds for specific deals during volatile market conditions and limited competition for deals.
The CA report highlighted the fact that LPs need to heavily rely on due diligence undertaken by GPs when making co-investments. This is because co-investment deals allow little time for LPs to undertake their own due diligence.
Marc Syz, Hong Kong managing director of ACE & Company – which specialises in co-investments – countered that co-investment can entail “better risk management and due diligence” as more participants undertake due diligence on deals. Further, his firm typically invests alongside sector or regional specialists, which he said adds expertise to the due diligence process.
The CA report found mixed results for co-investments. A total of 49 deals examined had outperformed, returning a gross multiple of 2.14x capital invested, compared to 1.45x for the relevant sponsor fund. But a greater number of deals (55, representing 56% of capital invested) had underperformed, achieving a 0.78x multiple.
Shaw said that the Asia PE market had fundamentally changed since the financial crisis. In the past, GPs could realise value by arbitraging between higher multiples in public markets than private ones. That difference between public and private market valuations no longer exists. Further, growth has slowed, resulting in GPs placing less emphasis on minority growth investing and more emphasis on control buyout investments.
That may open up opportunities for LPs who think that they can help initiate changes at the portfolio companies in which they co-invest alongside GPs. Syz cautioned that a lot of LPs are asking for co-investments “just to reduce fees”, without bringing operating experience to the table.
Shaw argued that it is very difficult to pick potential winners. “If you are only picking a small segment of that universe”, referring to a portfolio of investments made by a PE fund, “you might get lucky and get the real good ones, or you might be unlucky” he said.
Syz’s view is that co-investment is more about limiting exposure to investments that pad a portfolio than picking winners. He said that a “handful of investments” drive PE funds’ performance, with the rest of the portfolio merely serving as a drag on performance. He agreed that valuations for large deals are now very high but saw opportunities in smaller-size deals.
CA’s analysis suggested that LPs should invest in deals that fit with a GP’s “strike zone”. It found that co-investments that followed a GP’s investment profile achieved a multiple of 1.65x. In contrast, co-investments that veered from the GP’s stated strategy returned 1.02x on average.
“LPs pursue co-investments for two reasons,” said Syz, “because they believe that they can achieve better returns or to try and reduce fees”.
LPs’ desire to co-invest is "probably better addressed by giving a lower fee on overall participation in the fund rather than trying to let them go side-by-side on bigger deals," observed Shaw.
“What people really like about the ability to co-invest is just the lower fee,” said Shaw. Co-investments do not incur the fee charged for investing in a PE fund. Management fees on co-investments are often less than half those charged on a PE fund, according to CA.