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Are co-investments taking a back seat?

The number of investors looking to tap co-investments is dwindling year-on-year. PDI looks at what is driving this.

The subject of co-investment has been garnering growing interest over the past few years in the private credit space, though the number of deals taking place remains limited. In Private Debt Investor’s LP Perspectives 2022 Study, only 22 percent of credit investors say they plan to participate in co-investment opportunities in the year ahead, and that figure is going down over time, having hit a high of 36 percent back in our 2020 survey.

LPs say they are put off co-investing principally because they are not staffed up for it, but also because of the speed required to conclude transactions and the lack of available opportunities. All three of these concerns have increased over time, suggesting the challenges that prevent these transactions from getting off the ground are becoming more and more difficult to overcome.

Jess Larsen, CEO and founder of specialist placement agent Briarcliffe Credit Partners, says: “Often LPs get a short period of time to make a decision on these deals, and that can be a challenge. Within credit, the structures can be more complex than they are on your typical equity deal, and that makes them difficult for investors to move quickly.”

But despite these challenges, Larsen says the levels of activity are gathering pace. “Co-investment is certainly happening more and more in the credit space,” he says. “We are active in co-investment and we have more demand than product. It used to be just the large pension funds and some family offices that were equipped to do these deals, but we are now seeing a much broader mix of LP types looking to invest into co-investment.”

Co-investment requires greater resources and sophistication on the part of the LP but offers a cheaper route to participation on transactions in return. As such, a growing volume of such deals can be seen as a natural evolution of the market, with LPs initially accessing the asset class via funds of funds, then investing directly with a chosen group of managers, before next pursuing niche sector strategies, then co-investment, and ultimately doing direct deals independently. The complexity and sophistication of the mandates continues to increase over time.

Case in point is Connecticut Retirement Plans and Trust Funds, which allocates 0.7 percent of its $43.1 billion of assets under management to private debt. In June 2021, it approved its private credit pacing plan for fiscal year 2022, intending to diversify its private debt strategy allocations by introducing a 40-50 percent target exposure to senior debt alongside 10-20 percent to mezzanine debt and a new 10-20 percent allocation to co-investments.

On the fundraising side, sponsors in direct lending have been setting up co-investment funds and single investment co-investment structures to boost LP allocations to their overall direct lending platforms, while sovereign wealth funds developing a growing appetite for private debt globally have been forming partnerships with existing private debt GPs via co-investments and stake purchases.

Where investors can overcome the challenges, co-investment offers a good opportunity to increase exposure to the asset class while taking greater control over the investment.

“Co-investment is certainly happening more and more in the credit space”

Jess Larsen,
Briarcliffe Credit Partners

Jeffrey Griffiths, co-head of global private credit at placement agent Campbell Lutyens, says: “Where managers are unable to raise enough money to pursue the big ticket deals they would like to pursue, and while there is a lot of dealflow out there, there is clearly room for investors that are interested to come in and partner with managers. Co-investment allows managers to do deals that would otherwise be beyond their reach because they can’t raise enough fund capital.

“That’s much more of a factor at the upper end of the deal size segment, and less common in the lower mid-market where managers tend not to have an issue with doing deals on their own. We see some investors that will use co-investment as a means to average down their fees, but certainly co-investment remains less prevalent in private credit than it is in private equity. We think that will change as the market matures and more investors learn from their managers and build the in-house capabilities to look at these opportunities.”

For now, investors identify several factors putting them off co-investments, including a lack of opportunities to be invited to participate, ticket sizes, risk levels and governance restrictions. Investors are getting more comfortable with some of these issues though: only 14 percent of LPs said their governance or mandate prevented them from participating in such deals now, down from 20 percent in 2020.

Likewise, concerns about the risks associated with co-investment have diminished over time, identified as a factor hindering participation by 36 percent of investors in 2020 but worrying only 14 percent of investors today.