Everything investors need to know to get started in private equity co-investments
Co-investments are a unique segment of private equity which is attracting more and more investors. Here’s what you need to know to start your co-investment journey with confidence.
We are entering a demanding era for investors. As traditional investment approaches are being challenged, investors are looking to add to their portfolio tool-kit. A rising number are recognising private equity co-investments as a compelling way to enhance diversification, increase access to exclusive opportunities and optimise risk-adjusted returns.
Here, we dig into how co-investments work, what the investor journey looks like, as well as why and where opportunities are emerging.
What is co-investing?
Co-investments are direct investments made alongside a private equity sponsor into a portfolio company. These investments typically take the form of minority equity and, depending on the scale of the co-investor, can provide enhanced governance and information rights.
This way of investing can provide additional diversification across managers, sectors, strategies and geographies and even a higher degree of selectivity when assessing deals, compared to other private equity approaches. Co-investing also allows investors to engage more actively with underlying companies, ranging from everything from operational practices, to sustainability issues and behaviours.
There are four distinct steps in the process of private equity co-investment, each crucial to its successful execution.
In the sourcing stage, investors and private equity sponsors (general partners or “GPs”) collaborate to identify promising investment opportunities that align with their shared investment objectives. Private equity sponsors are a key part of the sourcing process, fielding deal flow from multiple sources in their industry networks and/or traditional sourcing channels like investment bankers. Co-investors contribute to this process by drawing from their own networks, market insights and track records and by working closely with their GP partners to identify opportunities.
Once a compelling opportunity is identified, the due diligence phase begins. This involves a comprehensive assessment of the target company, encompassing its financials, operational health, competitive positioning and future growth prospects. Co-investors, in collaboration with the private equity sponsor, use their collective expertise to scrutinise the investment, ensuring alignment with their investment criteria and risk tolerance. Thorough due diligence is essential in mitigating potential pitfalls and enhancing the probability of a successful co-investment outcome.
With comprehensive due diligence completed and investment approval secured, the co-investment process moves to the execution phase. At this juncture, co-investors and the private equity sponsor collaborate to structure the transaction and finalise the acquisition of the target company. Execution involves a series of critical steps, including legal documentation, governance arrangements and closing/funding.
This is an active, ongoing exercise that extends throughout the life of the investment. Key aspects of post-closing monitoring include: KPI monitoring, board-level involvement (typically via board observer seats for large co-investors), interaction with the lead GP and strategic value-add.
Through a thorough understanding of each element of the co-investment process, investors can be more attuned to the pain points at each step as well as opportunities to add value.
The rise of private equity co-investments
Co-investments in private equity are not a new phenomenon; they have been a part of the private equity landscape for decades. Historically, these investments were primarily reserved for large institutional investors who had the capital and connections to invest alongside private equity firms in portfolio companies. However, as the private equity market has evolved and matured, co-investments have become increasingly accessible and attractive to a broader range of investors.
Looking at the current trends and statistics, it’s clear that private equity co-investments are on the rise. Co-investments have seen a significant uptick in both volume and value over the past few years. Fundraising for co-investment funds has grown 10x from 2012 to 2022, according to Preqin, and a recent survey showed that 59% of LPs plan to increase allocations to co-investments in the coming two to three years. This growth is driven by several factors, including the desire for investors to have more control over their investments, the potential for higher returns and the opportunity for portfolio diversification.
The benefits of private equity co-investments
Co-investments in private equity offer several compelling benefits. One of the most attractive is the potential for higher returns. By investing directly in a portfolio company alongside a private equity fund, co-investors can often avoid the management fees and carried interest typically associated with fund investments meaning that a larger portion of the investment's returns go directly to the co-investor. Co-investments also provide access to unique investment opportunities that might otherwise be inaccessible. Many private equity deals, particularly in the middle market, are not widely marketed and are often only available to a select group of investors. By co-investing, investors can gain access to these exclusive opportunities, potentially uncovering high-growth prospects that are off the beaten path.
Another significant benefit is enhanced alignment and strong relationships with GPs. In the context of private equity co-investments, alignment refers to the shared interests and goals between the lead private equity firm and co-investors.
Alignment is beneficial in several ways. Firstly, it ensures that all parties are working towards the same end goal: maximising the investment's value. This mutual interest fosters a collaborative environment where decisions are made with the investment's best interest at heart. Secondly, alignment reduces conflicts of interest. Since all parties share the same goal, decisions are less likely to favour one party over another. Lastly, alignment can lead to increased transparency. With everyone working towards the same goal, there's a shared incentive for open communication and clear reporting.
In addition to the positive alignment, co-investments also enhance and deepen the relationship with GPs given the higher touch relationship LPs can have with GPs via co-investment. This enhanced relationship with GPs can result in better access to primary and secondary opportunities and a deeper understanding of their investment processes.
Where are the opportunities? The attraction of the middle market
We believe the middle market represents a significant and often overlooked segment of the economy. It is typically defined as companies with annual revenues ranging from $10 million to $1 billion. These companies operate across a wide range of sectors and geographies, making the middle market a diverse and dynamic segment.
Investors often focus their attention and capital on the well-known large and mega-funds that focus on acquiring larger portfolio companies, partly because of greater accessibility. However, we believe small and mid-sized company investments provide more attractive investment opportunities and upside. There are several reasons why mid-market investments can outperform:
- Fragmented market allows for high selectivity and consolidation opportunities
- Attractive entry valuations offer potential for significant multiple expansion
- Lower leverage ratios provide more conservative capital structures
- High potential for company transformation driven by operational improvements and business transformation
Additionally, the majority of the companies that are sold in the small buyout segment are sold by private families or corporate sellers, according to Pitchbook, who are often not solely focused on receiving the highest price on their sale. A strong and credible team to manage the business also really matters.
What’s more, companies in this segment offer transformational opportunities driven by strategic, operational and financial improvements. Skilled GPs can take a well-positioned company and engage in a number of activities that can enhance value. Examples of such activities include:
- Add-on acquisitions and/or market consolidations
- Geographic and/or product expansion
- Strengthening and supporting management teams
- Institutionalising financial planning and reporting
These factors allow for the critical levers of private equity value creation to be applied and can lead to increased performance and attractive investor returns. Leading managers in this segment are able to position companies for a broad and deep-pocketed buyer universe, such as larger private equity funds or strategic buyers at exit.
Keys to success in co-investment strategies
Implementing a successful co-investment strategy requires careful consideration and planning. It is not simply about identifying attractive investment opportunities; it is also about building the right infrastructure, processes and partnerships to manage these investments effectively.
Firstly, LPs, allocators and investors need to assess their own capabilities and resources. Co-investing requires a certain level of expertise and commitment, as investors will need to evaluate potential investments, negotiate deal terms and potentially play an active role in the oversight of the portfolio company. Investors also need to consider their risk tolerance and investment objectives, as these will shape the type of co-investment opportunities they pursue.
When it comes to implementing a co-investment strategy, there are several options open to investors:
- Develop in-house expertise and build a portfolio of co-investments. This approach offers the greatest level of control, but it also requires significant resources and expertise.
- Establish a mandate or joint venture with an experienced private equity firm. This can be a good way to leverage the expertise and resources of a seasoned investor, while still maintaining a degree of control and influence over the investment process.
- Investing in a co-investment fund. This approach offers upside via a fee-efficient and diversified fund that leverages the expertise and GP relationships of a seasoned LP/co-investor. However, it also offers less control as the portfolio construction process is outsourced to a professional fund manager.
Challenges and risks of co-investments
While co-investments offer significant benefits, they also come with their own set of challenges and risks. One key challenge is the need for a high level of expertise and due diligence. Co-investors must be able to evaluate potential investments, negotiate deal terms and manage their investments post-acquisition. This requires a deep understanding of the respective industry, the target company and the broader market dynamics.
Co-investments also often require a significant commitment of time and resources. Unlike traditional fund investments, where the fund manager handles most of the investment process, co-investors often need to be actively involved. This can be a challenge for investors who do not have the necessary resources or expertise.
In terms of risks, co-investments can also expose investors to company-specific risk. If the portfolio company underperforms, this can directly impact the co-investor's returns. Additionally, co-investments can also lead to concentration risk if the investor has a significant portion of their portfolio invested in a single company or sector.
Despite these challenges and risks, there are strategies that can help mitigate them. One key strategy is diversification. By spreading their investments across multiple companies, sectors and geographies, investors can reduce their exposure to any single investment. Another strategy is to partner with an experienced private equity firm or co-investment fund. These partners can provide the necessary expertise and resources to manage the investment process effectively.
There is no one-size-fits-all approach to implementing a co-investment strategy. The right approach will depend on the investor's resources, expertise, risk tolerance and investment objectives. Regardless of the approach chosen, it is clear that co-investments offer a compelling opportunity for investors seeking higher returns and portfolio diversification.
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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.