While no hard numbers on industry-wide co-investment exist, the consensus among private equity professionals and the trade press, including Private Equity International, is that record amounts of capital were earmarked for the strategy in 2024. Indeed, anecdotally attested record co-investment flow is happening at a time of generally depressed fundraising, leading some to wonder if we’re seeing an unhealthy glut of co-investment. Private Equity International notably explored such fears in a 19 November article titled “Co-investment binge triggers style drift concerns among LPs”.
But what the growth of deal-by-deal structures – whether co-investments or direct deals unassociated with a fund – really offers is the opportunity for investors to achieve the outperformance, or alpha, that comes with greater certainty and flexibility.
There is a tendency to attribute the success of co-investment to the low-to-no-fee nature of these investments, but the truth is that co-investment forces managers to find highly incentivised, off-the-beaten-path situations where outperformance is more likely than in a traditional, blind-pool private equity fund. Co-investment is, in fact, ideally suited for investments that don’t fit the relatively narrow parameters of traditional funds, whether that applies to deal size or strictures that dictate what industry or industries a fund can invest in.
The demand for (and success of) co-investment also means it is increasingly being paid for in the form of tiered super-carry structures. These structures arguably align the outperformance goals of GPs and LPs even more tightly than a classic 2-and-20 commingled fund structure. This is particularly true given the low-to-zero fee structure of all deal-by-deal activity, including both co-investment and direct investing.
Other co-investment characteristics militate against the supposedly pernicious effects of style drift, including the identification of assets ahead of investment, permitting today’s increasingly sophisticated investors to kick the tires on an investment themselves rather than just trusting the GP to do this. The inherent flexibility of co-investment parameters also permits managers to opportunistically shift their focus to companies in industries adjacent to or even wholly outside of a fund’s remit – particularly when a fund’s focus industries are the subject of intense bidding wars.
But the biggest insurance policy against out-of-strike-zone investments is that co-investments must succeed for managers to continue raising money from investors. If anything, this is even more crucial than commingled fund success. A failed co-investment can’t be hidden under a passel of more successful investments. However, a failed investment that is part of a commingled fund can be hidden away.
Apart from kicking the tires on an investment yourself, one of the best ways of vetting whether it’s worth co-investing with a manager is to look at their co-investment track record. If the track record is there, unduly focusing on the similarity of the portfolio manager’s companies is a waste of time.
Co-investments can often have another important advantage over fund investments. Given their increasingly separate carry terms, they are often insulated from so-called fund bias. When a traditional fund hits its carry hurdle based on the performance of just a few of its top portfolio companies, there is a strong temptation for the manager to sell off the entire portfolio as soon as possible, even if there’s still considerable growth potential in many of the investments. They take their profits, even if there’s a good reason to let remaining investments ride, and they are free to replenish their fee-producing coffers with a new fundraise.
In contrast, when governed by a separate compensation structure, co-investment encourages GPs to realise the full potential of each investment – they are less likely to leave an LP’s money on the table with a co-investment than a traditional fund investment.
There will always be justified demand to invest in established fund series with stellar track records or in new managers with demonstrable expertise in a particular strategy. Still, investors are increasingly looking to groups with a proven capacity to find the elements of outperformance in highly incentivised deal-by-deal structures where assets are identified ahead of investment and where there is no fund bias.
Today’s record demand for co-investment will lead to some ill-considered investments, but more often than not it seems to be leading well-managed GP groups to look even harder for ways to improve investment flexibility and increase the odds of top-quartile performance.
I would posit that co-investment has years of above-average growth ahead of it. Indeed, one day in the not-too-distant future I expect to see such deal-by-deal investments match the volume of traditional private equity fund investments.
Matt Swain is head of direct placements and secondaries within Houlihan Lokey’s private funds group.
