The Co-Investment Conundrum: Trust Thy Partner

Co-investment is growing in popularity but poses dangers. The first step: Build trust.

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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 to 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 percent 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.

The co-investment era would seem to be on its way. In fact, it may already be here. As this Preqin report shows, half the LPs surveyed are pursuing co-investments and more are on the way. 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’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.

The term “co-investment,” as Rajiv Sharma and I explain in a recent working paper, is often used to refer to institutional investors investing in companies alongside their external asset managers. Most studies 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 favorable terms than 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 is 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 this type of 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.

The big question for many LPs then becomes: How can I trust GPs, many of whom have been fined by the Securities and Exchange Commission for overcharging me? Great question. It is for this reason that many Giants are now looking to co-invest with investors that are not GPs. Here are a few examples of what I’m talking about:

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- 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.)

- Cousins: There are clear benefits to one type of long-term investor 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 joint venture can offer 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.

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 a trustworty partner, even co-investing with top GPs may lead to significant underperformance. So, how do you develop trust with other co-investors?

Obviously, you want to maximize alignment of interests, but even among peers this can be very complex. (I went into this at length in my previous column.) 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 the cultivation of real, trust-based relationships is, I believe, the secret sauce to effective co-investing.

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 such relationship building. This may seem 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, even if crucial individuals leave. This may be important for convincing boards of the value of traveling 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.

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