Maria Prieto, Senior Investment Director, Schoder Adveq
Richard Damming, Senior Investment Director, Schroder Adveq
Tom Lewis, Alternatives Director, Schroders
Investing in a post-crisis period is never simple. The atmosphere of opportunity compels investors to put capital to work. However, where and how to best invest becomes more important than ever.
As public markets appear disconnected from the reality of company fundamentals - and volatility remains - private assets are increasingly an attractive area for investors. In private equity, history would appear to support this theory – fund vintage performance is best in the one to two years following a crisis.
Deploying capital into private equity requires local knowledge and experience of routes to market. A traditional private equity fund may, on the face of it, seem an obvious option. However, the wrong manager in the wrong geography or sector could end up holding onto investors’ commitments for 12-24 months without deploying capital (whilst still charging fees). They may make concentrated bets in particular market segments. In both cases, there is a danger of missing the market opportunity. A co-investment strategy can help to ensure that these pitfalls are avoided.
Why are co-investments particularly well-suited to the shift towards a post-crisis era, and how can co-investment capital be put to best use?
Co-investments provide Limited Partners (“LPs”) with the opportunity to invest directly into businesses alongside General Partners (“GPs”). LPs with access to a broad range of GPs have the ability to flexibly allocate to most attractive market segments and may even have a higher degree of selectivity when assessing deals.
In times of crisis the most anticipated opportunity for co-investments is the ability to invest at lower entry valuations and attractive terms. Historically there has been a lull in new investment and divestment activity immediately post crisis, as sellers try to avoid the down-market.
However, when financial markets catch up with business fundamentals, it is often only to step into an environment of significantly reduced liquidity across the market.
Non-financial investors (business management) stop investing to focus on operational matters and potentially even look to divest non-core assets to shore up liquidity; financial investors also reduce investment activity as fundraising slows down and dry powder falls. Overall competition for deals falls and sellers have to adjust to a new reality.
Co-investments rely on strong relationships with GPs, and this is even more applicable during times when M&A activity drops. Access to deals will be reserved for LPs with the closest GP relationships and the most proven execution skills. GPs with less experienced co-investors may also look to third party co-investors for certainty of execution. For experienced and well-positioned co-investors, the current market environment can lead to increased access to deals with lower competition.
Covid-19 has had non-uniform impact across different segments of the private equity investment landscape. Whereas some segments are likely to benefit from changes in consumer behaviour, technology developments and regulations, others will struggle temporarily or permanently.
Co-investments can put money to work in numerous, value creative ways, depending on the vulnerability (or lack thereof):
Offensive investments in healthy businesses to accelerate growth
The Covid-19 crisis has accelerated many changes in consumer behaviour, giving a strong boost to digital products and services, and also highlighted the resilience of the healthcare and business to business (B2B) technology sectors. These areas provide attractive growth opportunities, albeit likely at premium valuations. The greatest challenge for co-investments will be to assess whether growth is permanent or limited to specific dynamics around lockdowns.
Other resilient sectors, which may not have directly benefitted from the crisis but have held well, also present attractive opportunities. Well-capitalized businesses will be able to acquire less stable competitors at good terms. Shareholders with a strong liquidity position may be able to increase their pro-rata ownership by providing liquidity to other investors.
Defensive investments in harder hit sectors
The crisis has hit businesses that have robust business models, but that sit in sectors that are struggling due to lockdown measures. These are fundamentally sound companies, which need investment to endure a temporary period of hardship. Co-investments in such companies can allow entry at a reduced valuation, and the opportunity to use investment to take market share as economies reopen.
Themes of opportunity
Post-crisis co-investments will capitalise on changes in consumer behaviour across all industry groups. The following themes are emerging as areas of focus:
As previously mentioned, there is not a common theme or sector, and therefore a diversified co-investment strategy is likely to represent the best way to access all of these business areas in a timely manner.
Thinking ahead to the exit conditions that await co-investments made now, there are a number of drivers favouring a future seller.
The effects of this crisis will add a strategic premium for non-correlated business models; those insulated from the cyclical downturn. Companies that have demonstrated robustness or counter-cyclical qualities will likely be in high demand, as investors look for businesses that can insulate themselves from future crises.
In addition, financial and strategic/corporate investors who have held off investing for a period of time will likely provide a strong backdrop of demand returning to the market in search of strong companies in a normalized market environment.
A co-investment strategy is an effective and agile way to access the current market opportunity.
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