Mark my words: We’re going to see a lot more co-investing in private markets in the next few years. The volatility in public markets will push Giants – especially those with strict return expectations, such as pension funds – further into private markets due the lower relative and reported volatility and higher nominal returns. But while private markets may offer benefits, they also happen to be extremely costly, with endemic misalignment among managers. As such, some Giants are looking to go direct, which is smart: Research shows direct investors outperform fund investors by 3.2% per year. But going direct is very hard. Most Giants will never have the internal resources to build effective direct investment capabilities for private markets. So they’ll look to build these capabilities jointly – pooling resources with others and… co-investing.
In short, the co-investment era would seem to be on its way. In fact, the co-investment era may already be here. As this Preqin report shows, half of all the LPs it surveyed are now pursuing co-investments and more are on the way (see, also, here, here and here). This begs the question whether all of these LPs have put in place the internal resources required to do this effectively. Have the Giants even given thought to how they should select co-investment partners? I ask because I’m not sure the LP community really gets how hard this is. When done correctly, co-investing is the highest form of collaboration and cooperation. It’s not something, in my humble opinion, that can be successfully automated and bolted onto an agreement with a manager; co-investing demands its own strategy. And that’s what I’d like to talk about below.
The term ‘co-investment’, as Rajiv Sharma and I explain in a recent working paper, is often used to refer to institutional investors investing alongside their external asset managers into companies. Most studies of co-investment also adopt this definition. In our paper, however, we take a much broader view of co-investing. We view it as any collaborative investment that seeks to facilitate access to opportunities on more favourable terms than in the traditional fund model. Co-investing need not be with GPs alone. In fact, GPs may not even be great co-investment partners. The data on LPs co-investing with GPs are mixed. There are, of course, reports that suggest co-investment returns are higher than fund returns. But there are also peer-reviewed studies that show co-investing underperforms direct (solo) investing and fund investing.
In other words, co-investing with GPs may be the single worst way to access private equity! Let that sink in for a second. You may be wondering, how can PE investing without fees underperform PE investing with fees? Some believe GPs lack the incentive to bring their best deals to their LPs for co-investments because the fees aren’t as good. That means the deals you’re seeing as a co-investor aren’t the GP’s highest conviction deals.
This goes to the heart of the co-investment conundrum: It’s very hard to judge if you’re being shopped a “lemon” or if you’re seeing a truly great deal. Even among the most talented private equity investors, trust, it seems, is paramount. Yes, there’s a balancing act between that one need to assess the capabilities of a co-investor and the trust you have in that investor. Even still, trust matters.
The big question then becomes for many LPs: How can I trust GPs that have been fined by the SEC for over-charging me? Great question. It’s for this reason that many Giants are now looking to co-invest with investors that are not GPs. Here’s a few examples of what I’m talking about:
- Siblings: Some Giants are forming co-investment partnerships with like-minded investors to deploy capital collaboratively into attractive investment opportunities. (Here’s an example of one. And here’s another.)
- Cousins: There are clear benefits to one type LTI working with a different type of LTI. Maybe you’re an endowment that wants to partner with some family offices that have privileged access to operating companies? Maybe you’re a pension fund that wants to co-invest alongside a sovereign development fund with proprietary deal flow? Given the performance of some SDFs, that’s not at all crazy.
- Companies: Partnering directly with a development or engineering company through a JV can facilitate the strategic advantage of investing in an emerging economy while simultaneously achieving the efficiency of direct investing. (Here’s one example.) Some funds are even setting up new platform companies with peers in order to get high quality deal flow.
In sum, co-investing with GPs may be on the rise, but so are other forms of co-investment. In fact, there are so many of these new collaborative investment platforms emerging that a report came out this week saying that – surprise – collaboration among asset owners seems to be harming the interests of asset managers.
So let’s come back to the main issue at hand: Co-investments are on the rise. But doing co-investments demands trust. Without trust, even co-investing with top GPs may lead to significant underperformance. So, a natural question follows: How do you develop trust with other co-investors?
Well, there are some tricks to the co-investment trade. Obviously you want to maximize alignment of interests but even among peers, this can be very complex - something I went into at length in my last column, so I’m not going to go into it here. But that’s critical. You also want to make sure that you’re doing the standard constructive things you’d want from any partner, such as providing fast responses and being able to close a deal on a set deadline. But beyond these basics, there’s the cultivation of real, trust-based relationships. This, I believe, is the secret sauce to effective co-investing.
But this is where things get a little bit troubling. In my experience, most Giants don’t fully appreciate or even acknowledge the need to build deep relationships with other organizations. They don’t have an internal capability to manage relationship building with other organizations. You may think this is odd given how much attention is paid to “networking” by GPs in private equity and venture capital. But it’s true. How many pension funds or sovereign funds can you name with an internal capability specifically focused on network management? One? None? Now square that with the fact that half of the LPs surveyed by Preqin are, today, pursuing co-investment opportunities. Don’t you find that worrying? I do. I’m worried these investors will all end up buying a bunch of lemons from the private equity equivalents of used car salesmen.
It’s for this reason that Rajiv and I argue (in a different paper) that institutional investors need to systematically develop an efficient and effective network and enhance their social capital to facilitate trust-based co-investment relationships. We are also looking at how software can be used to manage the dynamic complexity of relationships for an organisation, even if crucial individuals leave. This may be important for convincing Boards of the value of travelling around the world to build relationships. No doubt the development of trust can be a lengthy process. But if you aren’t taking your social capital seriously – actively working on trust with potential co-investors – then you shouldn’t be co-investing with anybody… not even your own GPs.