Limited partners (LPs) are increasingly worried about the implications of a surge in co-investment capital, which is being driven by a challenging fundraising environment for blind-pool funds. This trend raises concerns that some general partners (GPs) may venture beyond their traditional investment strategies, potentially leading to style drift.
Key Takeaways
The rise in co-investment capital is a response to difficulties in raising funds for blind-pool investments.
LPs are concerned that GPs may stray from their core competencies due to increased co-investment opportunities.
The bespoke nature of co-investment rights complicates LPs' ability to assess the total capital available to GPs.
As the fundraising landscape becomes more competitive, many firms are leveraging co-investment rights to attract LPs. These rights are appealing to institutions because they often come with favorable economics, enhancing overall returns. David Scopelliti, global head of private equity and private debt at Mercer, notes that GPs are incentivizing LPs with offers of one-to-one co-investment opportunities.
Co-investment capital allows managers to pursue larger acquisitions that might exceed concentration limits in their blind-pool funds. However, this trend raises alarms among investors who fear that an influx of co-investment capital could push GPs to engage in larger deals that fall outside their expertise.
Steve Hartt, a managing principal at Meketa Investment Group, emphasizes that co-investments often involve larger opportunities, which can lead GPs to stray from their established investment strategies. He warns that LP demand for co-investments could pressure managers to pursue larger transactions, potentially compromising their investment discipline.
Allen Waldrop, deputy CIO for private markets at Alaska Permanent Fund Corporation, echoes these concerns, suggesting that LPs should carefully consider the implications of co-investment capital. He questions whether investors are backing a manager with a $5 billion fund or one that effectively operates with an $8 billion or $10 billion fund due to co-investments.
Due Diligence Challenges
The unique nature of co-investment rights makes it challenging for LPs to gauge how much capital is available to a manager. Hartt points out that co-investment capital has traditionally been difficult to quantify, leaving LPs uncertain about the commitments made by GPs to their investors.
To navigate this uncertainty, some investors are scrutinizing the composition of a fund's LP base more closely. Christopher Bär, managing director at Munich Private Equity Partners, highlights the importance of understanding the dynamics between LPs and GPs to assess the pressure on managers to deploy capital beyond their fund size through co-investments.
Another strategy for LPs is to evaluate existing co-investments made by a manager. Hartt suggests that LPs should consider whether a manager's approach to new investments aligns with their previous successes. If a manager is pursuing a strategy that diverges from their historical expertise, LPs may need to exercise caution.
Despite these efforts, it remains challenging for LPs to rein in managers who venture beyond their core competencies. Hartt notes that if an LP declines a co-investment opportunity due to concerns about style drift, another investor may step in, making it difficult to enforce discipline among GPs.
The Future of Co-Investments
The appetite for co-investments is unlikely to diminish anytime soon. Scopelliti warns that GPs accustomed to offering co-investment rights in a tough fundraising environment may find it difficult to retract these offerings when conditions improve. He likens the situation to letting the genie out of the bottle, suggesting that the landscape of private equity investing may be permanently altered by this trend.
In conclusion, while co-investments can provide valuable opportunities for LPs, the potential for style drift among GPs raises significant concerns. As the private equity landscape evolves, both LPs and GPs must navigate these challenges carefully to ensure sustainable investment strategies.
Sources
Co-investment binge triggers style drift concerns among LPs, Private Equity International.