Why Co-investment Funds Outperform in Private Equity

Private equity managers wouldn’t offer bad deals to investors because their “limited partners pay the bills,” said a Capital Dynamics senior managing director.

Illustration by II; Bigstock

Illustration by II; Bigstock

Co-investing is becoming more popular — and with good reason, according to new research from private markets firm Capital Dynamics.

Citing a recent academic study and its own analysis of Preqin data, the multi-manager firm found that co-investment funds have outperformed single-sponsor private equity funds on a net basis over the last two decades.

For funds launched between 1998 and 2016, 60 percent of co-investment funds delivered a higher net internal rate of return compared to single-sponsor funds. During the later vintages of 2009 to 2016, a still greater proportion of co-investment funds outperformed — and the results were similar when Capital Dynamics evaluated performance using multiples instead of IRR.

This outperformance does not appear to stem from better deal-making. According to a recent academic study from researchers at the Technische Universität München and University of Oxford, co-investment deals are as likely to be good or bad as any other private equity deal.

As Capital Dynamics senior managing director Andrew Beaton explains, co-investment opportunities typically occur when general partners identify deals that they can’t afford on their own. These deals are not necessarily better investment opportunities than other deals those general partners have made — but the co-investment deals are not likely to be worse either.

“They don’t want to take a transaction to a limited partner that they would feel uncomfortable about,” he said in a phone interview. “Limited partners pay the bills. It would not make any sense to deliberately damage that relationship.”

Given that co-investments “perform pretty much the same,” the primary source of outperformance for a co-investment fund, according to Beaton, is fees.

“The standard fee structure for a multi-manager co-invest fund is about 1 and 10,” said Beaton, who oversees co-investment funds at Capital Dynamics. “The famous 2-and-20 model for private equity means the fee structure for co-investment is about half. All other things being equal, net returns would most likely be higher.”

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These lower fees have proven to be a strong draw for limited partners seeking to invest in co-investment funds or make their own co-investments. For example, a 2019 survey by Cerulli Associates found that 75 percent of hospitals and health-care systems were targeting more co-investments within alternatives.

“There is certainly more demand for co-investments,” Beaton said. “LPs are seeking to get a fee break, and recognize that co-investments are an attractive opportunity.”

Still, while co-investment deals might work well in private equity strategies such as buyouts, Beaton warned that they could be less effective in situations where the general partner and co-investor are on less even footing. For example, in venture capital.

“If you think about the way in which venture capital works, the sponsor will put up a small amount in the B round, and the need for co-investment won’t arise until the C or D round,” he says. “Effectively what you’re doing is investing at a different price than the lead sponsor.”

Co-investments are more effective when the general partner and limited partner go “toe-to-toe,” Beaton explained. “We want to invest on the same terms, at the same price, and at the same time as the sponsor.”