David Morse, the global co-head of private equity co-investments at Neuberger Berman, and his colleagues have been especially busy this year.
Private equity investors in need of liquidity are being forced to get creative with an uncommon type of deal. So-called midlife co-investments — when a PE firm sells part of its stake in a portfolio company to one of the fund's limited partners to raise cash — are up significantly based on observations by Neuberger Berman. The asset manager, which is one of the few with a strategy dedicated to buying those stakes, says deal flow during the second half of 2021 and the first half of 2022 rose almost 60 percent, and it was up over 80 percent in the first half of 2023 compared to the same period last year.
With most co-investments, a private equity firm and one of its limited partners invest concurrently in a company, or the PE firm brings in a new investment partner. But a confluence of things have led to more midlife co-investments.
Kevin Gallagher, a principal at Casey Quirk, the strategy consultant to some of the biggest asset managers, said that midlife co-investments remain a small, niche part of private equity but he's "not surprised that this is becoming a topic of interest."
Investors, whose allocations to private equity have grown as the value of public equity and other asset classes has fallen, are trying to rebalance portfolios and are pressing managers for distributions. But private equity firms are strapped in the current economic environment, with some portfolio companies generating less cash and whose valuations have declined.
Strong pressure on prices has general partners considering all kinds of ways to hold onto their equity, according to Agnès Lossi, a partner at INDEFI. A midlife deal is a "very good way to offer co-investments to current LPs in order for them to get the same exposure at the best price. That could be the reason why these middle life co-investments are developing," she said.
Meanwhile, as interest rates rapidly rose and traditional banks dramatically pulled back their lending, debt financing has gotten more expensive (even as private credit has grown to fill the void). Private equity funds that don’t have as much pressure from limited partners asking for distributions are still in a tricky spot. They might want to go on offense and make investments, but loans to fund transactions are expensive.
“They went from a situation in 2020 where distributions were exceeding capital calls, to exactly the opposite place. Now capital calls are exceeding distributions,” Morse said.
To generate the cash they need, private equity firms have turned to co-investing, including in the form of selling slivers of their portfolio companies to their limited partners.
“There's been a big trend in minority transactions as an interim measure to create liquidity because sponsors in this uncertain environment are less likely and less interested in selling companies outright because they're not sure what price they're going to get,” Morse said. “So a mid-level step is to sell a minority interest to a co-investor and generate some liquidity.”
But not every investor can do it. Many limited partners are already overallocated.
So PE firms that don't necessarily want to sell right now are turning to Neuberger Berman, which builds portfolios of co-investments, and some pension and sovereign wealth funds with which they have long relationships and are opportunistic investors.
Neuberger Berman and other institutional investors don’t switch their co-investment programs on and off like some other limited partners, such as family offices, according to Morse.
“They'll come back at some point when the over-allocation to private equity corrects itself, but in the meantime they're on the sidelines,” Morse said.
It’s going to take time for that correction to happen and even after it does, interest could remain high.
“Private equity firms are wrapping their heads around the fact that debt is going to be a much more expensive form of financing today, tomorrow, and potentially years into the future — the rocket fuel of 0 percent interest rates is not coming back,” Morse said.
“There's going to be more equity in deals going forward for a long time, and that's going to involve co-invest. Our expectation is that this expensive debt environment's going to continue and capital structure is going to have to have more equity and that will also continue well into the future.”
