The great conundrum over co-investments

Limited partner appetite for co-investment opportunities has dropped to a three-year low as credit investors hold back from doubling up with fund managers.

According to Private Debt Investor’s LP Perspectives 2021 Study, fewer than one in four LPs expect to participate in co-investments over the 12 months to September. The figure is down significantly on the percentage this time a year ago and stands in stark contrast to the views of private equity investors.

At the start of 2020, co-investments seemed to be emerging as an increasingly popular method for investors to reduce fees and maximise returns. At the time, 36 percent of LPs expected to participate in deals alongside familiar managers during the year ahead.

But although such opportunities may offer fee savings – in addition to the chance for LPs to double-up on their favourite managers, sectors and geographies – some of the shine has gone off co-investments in the credit sphere during the pandemic. Just 23 percent of LPs expect to participate in co-investments in private debt, compared with 71 percent who expect to do so in private equity.

“Our experience has been that there are a relatively small number of large institutional LPs on the credit side that have the capabilities to execute on co-investments,” says John Anderson, counsel in the London office of Debevoise & Plimpton. “The transactional dynamics are different to private equity and require that they move very quickly. With the private debt fund GP, they are co-investing with having less control over the overall transaction process.”

Anderson says there may also be a lack of co-investment opportunities constraining supply, as private equity sponsors make reservations for their own co-investors in certain parts of the capital stack.

Co-investment can also fall into the category of ‘easier said than done’. When asked what puts them off such opportunities, one in four LPs say they do not have enough staff, while 34 percent say they are put off by the speed required to conclude transactions.

“Competition for the best opportunities and the ability to execute in a reasonable timeframe continue to be the major obstacles,” says Andrew Beaton, senior managing director on the co-investment team at Capital Dynamics. “Some investors also lack the investment experience and expertise to tackle co-investment.”

Co-investment can also lead to potentially troublesome concentration issues. “Co-investments are, by nature, concentrated bets into single companies,” says Mikael Huldt, head of alternative investments at AFA Insurance. “The advantages are obvious if you can get access to the right deals. But you need to bear in mind your total portfolio exposures and risks so that you don’t end up with unwanted overweights in certain areas.

“Also, as a limited partner, you need to be comfortable that you have the resources and processes, as well as the additional capital available for additional support, to effectively deal with any such opportunities.”