An expert insight: Key considerations
for co-investing
A Q&A with Steve Moseley, Wafra, and Ziad Sarkis, Ariska Capital
With lengthening timelines between fundraises, sluggish deal flow and limited exit opportunities, it is no wonder co-investment has experienced a surge in popularity, gaining steam as an opportunistic add-on to a diversified portfolio. Limited Partners (LPs) today are hungry for yield and they want to be more hands-on in boosting their exposure to the companies and sectors that are growing.
We recently caught up with Steve Moseley, Managing Director at Wafra, and Ziad Sarkis, Managing Director, Ariska Capital and Senior Fellow at the Wharton School’s Harris Family Alternative Investments Program, to discuss some of the evolving opportunities and risks of this collaborative strategy, as well as the key ingredients of a successful co-investment partnership.
LP appetite for co-investment varies depending on market conditions, investor preferences, and the specific opportunities presented. This is driven by several factors:
Potential for enhanced returns: Co-investments can offer the opportunity to directly participate in specific transactions alongside the general partner (GP), potentially leading to higher returns compared to traditional fund investments.
Alignment of interests: Depending on how they are structured, co-investments may align the interests of LPs and GPs more closely, as both parties have a direct role in the success of the investment. When the investment succeeds, both the LP and GP benefit proportionally. Conversely, if the investment underperforms, both parties share in the losses, fostering a sense of shared accountability and alignment.
Fee savings: Co-investments typically involve lower, or no fees compared to investments through the fund structure, which can be attractive to cost-conscious allocators.
Portfolio diversification: Depending on how they are structured, co-investments may allow LPs to diversify their portfolios beyond the investments made through existing funds, potentially reducing overall portfolio risk.
In the current environment of macroeconomic uncertainty, co-investment is.growing in appeal as a resilient strategy, with potential benefits for both LPs and GPs.
A properly executed co-investment program offers investors exposure to some of the best investments sourced and managed by some of the most skilled and successful investment firms. But rather than paying a premium for this access, investors avoid the “two and twenty” fees and carry that would otherwise diminish performance.
Reducing fee drag is a good start. But there are other benefits from co-investing that can have even greater impact. Many active co-investors, for example, use co-investments to increase exposure to targeted industries or geographies. And the co-investment process itself is a rich source of intellectual capital. Lessons learned about sponsors, industries, and companies will inform and improve primary fund commitment activity.
Fund commitments and co-investments are only two potential elements of partnership between GPs and LPs. Broadening and deepening these connections leads to improved alignment and better outcomes for all parties.
Concentration risks:
The point of investing in private equity funds is to seek diversification across multiple assets, geographies, etc. Co-investments do affect that diversification and result in a potential concentration of risk for the LP
GP bias risks:Competition for co-investment opportunities can sometimes result in limited access to attractive deals. Indeed, the availability of co-investments can push the GP in the direction of executing larger deals that may not be possible for them without co-investing capital.
This may drive GPs away from smaller but possibly more lucrative deals.
Co-investments can lead the GP to have a closer relationship with the LPs that are more active in co-investing and who can write larger checks. This may not always be favorable to other LPs.
Execution risks
Executing an investment often involves navigating a complex set of legal, financial, and operational considerations. It requires coordinating with the GP to ensure that the deal is structured effectively and executed efficiently under tight deadlines. This includes negotiating terms, conducting due diligence, securing financing, and finalizing legal documentation. Not all LPs are properly equipped to do that properly.
Once the investment is made, co-investors may face operational challenges in managing and optimizing the performance of the acquired company without necessarily having enough power to affect decision making.
Dilution risks:
If the co-investment opportunity generates significant interest from co-investors, there is a risk that the total capital sought by investors exceeds the available allocation.
This situation is known as oversubscription, where demand surpasses supply. When the co-investment allocation is oversubscribed, the GP may need to allocate the available capital among multiple co-investors.
As a result, each co-investor's portion of the investment may be reduced, leading to dilution of their ownership stake in the underlying company.
Dilution can have implications for co-investors' returns, particularly if you factor in the amount of resources and transactional costs the LP may have allocated on that deal. A smaller ownership stake may also affect co-investors' ability to influence decision-making or participate in governance matters related to the investment.
Indeed, the availability of co-investments can push the GP in the direction of executing larger deals that may not be possible for them without co-investing capital.
“Partnership” and “alignment” may be the two most overused words in our industry. But both are essential ingredients of a co-investment partnership and performance depends on the willingness of both GP and the LP to embrace these factors.
A lasting partnership requires meaningful contributions from both parties. The best co-investors are quick, candid and capable. And the more resources a co-investor can bring to the table (e.g., relevant advisors, or timely warehousing), the more valuable their partnership is to the sponsor and, one can expect, the better their investment outcomes.
Most GPs have some experience with co-investments and most of these GPs have refined and improved their co-investment process over the years. GPs also need to be quick, candid and capable. They should know the investment objectives of their co-investors and accommodate each LP’s circumstances. Often that means recognizing and planning around resource constraints.
The qualities of a good co-investment partner are also dependent on the party seeking this partnership as different organizations have different priorities and goals. However, I would summarize the key qualities one should seek as follows:
Track record of successful investments and value creation
Alignment of investment strategies and objectives
Transparent communication and strong relationship management
Ability to provide value-add beyond financial capital, such as industry expertise or operational support
Flexibility and willingness to accommodate the needs and preferences of co-investors
Favorable power dynamic (i.e. A relatively smaller player can rarely have much bargaining power with a much larger partner or if the partner is executing co-investments on its home turf in a foreign country, etc.)
