The “capital gap” and why it spells opportunity for co-investments

Private equity co-investment is a collaborative strategy. Investors participate directly - alongside private equity sponsors (GPs) - in specific transactions.

Read more - Everything investors need to know to get started in co-investments

This degree of collaboration makes it unique, and as the wider investment landscape has become more demanding, a growing number of investors have been attracted to co-investment strategies.

Here we explain how several key market trends, as well as a pressing need for capital, are elevating the use and value of co-investments as components of investors’ toolkits.

Macro shifts have created opportunity

The private equity market is not immune to macro factors. In recent times, it has experienced a series of transformative shifts.

Rising interest rates, a slowdown in mergers and acquisitions (M&A) activity and a change in the pace of private equity fundraising are particularly powerful forces. As they’ve moved through markets they have carved out a “capital gap”, which we believe is an opportunity investors should look at closely.

Filling the capital gap

The capital gap has emerged in many private equity transactions, but particularly in levered buyouts (LBO).

This is a result of lower debt availability. Banks have retrenched from the lending market, and the absolute and relative amount of leverage (typically measured as debt/EBITDA) offered in transactions by many private credit providers has decreased.This retrenchment in the leverage market has coincided with a rapid rise of interest rates in the past 18 months, making higher leverage in transactions less attractive. As a consequence, the equity contribution as a percentage of transaction value trending up materially in 2023

The backdrop of rising equity contributions is important to consider in the context of fundraising for private equity funds. PE sponsors are operating in a significantly different fundraising environment than prior periods, creating a challenge in getting many deals closed. 

This confluence of higher equity need, less attractive/less available debt financing, and slower fundraising has created a void in the capital structure. It is here that co-investment has found its niche, stepping in to provide the necessary capital where traditional sources of capital fall short.

This gap is illustrated below in two distinct scenarios. The first is in a more “normal” market where leverage is more available and fundraising momentum is more positive, leading to higher equity cheques available from a private equity sponsor’s fund. The second illustration is reflective of the current market conditions and a snapshot into the role that co-investment is playing in the current environment. 

The above is for illustrative purposes only and does not constitute investment advice.

Co-investments can fill a critical need in capital structures, but success in co-investments still depends on a number of factors. To ensure deal access and positive outcomes, co-investors need to be able to demonstrate the below key qualities.

Certainty and speed of execution

Co-investors are differentiating themselves by offering certainty and rapid execution in a competitive market. This has become a valued trait, especially in time-sensitive transactions.

Industry and market knowledge

Co-investors with industry expertise and deep market knowledge are in high demand. Their ability to quickly grasp the nuances of a deal can be a game-changer.

Increased focus on ESG

LPs are increasingly demanding that their co-investment partners incorporate ESG factors into their investment process, post-close monitoring and value-add.

Increased use of co-investment funds/outsourced providers

Co-investment funds are becoming increasingly popular as a way for allocators and investors to efficiently invest in co-investment opportunities. These platforms provide LPs with access to a diversified pool of co-investments and can help them to streamline the co-investment process in a highly fee-efficient manner.

We believe the capital gap is a trend that is here to stay, and will continue shaping private equity co-investment. However, it is crucial that investors develop an understanding of the risk and reward of these strategies, and work with the right partners to best navigate the ever-evolving environment.