Over the past several years, the use of co-investments by investors as a means to enhance returns has evolved. While once seen as a high risk/high reward, one-off venture used by aggressive investors and offered by similarly aggressive hedge funds, co-investing is now close to becoming a hedge fund strategy in its own right. However, acceptance of a strategy of seeking out single one-off opportunistic trades comes with additional risks that investors would be wise to heed. As with any market, the supply of opportunity will inevitably rise to meet the demand, meaning that if there are allocators willing to provide capital, co-investment opportunities will undoubtedly appear in an attempt to procure that capital. Managers are especially attracted to the possibility of raising capital quickly and locking it up for longer than their standard offerings. This raises the potential for a riskier overall strategy as less suitable and/or less well-thought out opportunities are marketed across the industry.
Investors must acknowledge the benefits that co-investments bring to managers and develop robust processes to make sure the risks they take justify the benefits they may receive. Indeed, while investors may no longer face the same career risk they once did when making these investments, risks to the end investor may in fact increase due to the growing perception of ubiquity which accompanies the growth of acceptance. Investors would be well served to remember the healthy skepticism they previously had when approached with these types of investments.
A basic framework for investors evaluating co-investment opportunities is presented here that consists of five principles to have in place throughout the evaluation process and five questions that an investor should be comfortable answering before allocating capital to a co-investment.
- Never rush the decision. Investors are usually given a sense that they will miss out if they do not act quickly. Managers may themselves create this sense of urgency to prod an investor “competition” to grab an investment before it’s gone. Investors should never invest if they have not had enough time to get all of their questions answered or to complete their own due diligence and research. No investment is good enough to justify the risk of acting too quickly. Investors will be able to meet tighter deadlines as they gain experience from reviewing more deals but even the most seasoned investor should take great care to avoid being rushed into a decision.
- Hold managers accountable. Managers should be sensitive to the increased risk that investors are taking and aim to be as accommodating as possible. The standard for co-investments must be higher due to their lower liquidity and the concentration risk. Managers who simply throw things against the wall to see if they stick; that is, those who pitch underwhelming opportunities to their investors or who unnecessarily lock investors up or who demand unfriendly terms should be viewed with heightened skepticism by investors. Managers not willing to answer each and every question or who share the bare minimum should generally be avoided.
- Align incentives properly. As a matter of practice, management fees should be much lower than they are for flagships, and performance fees should be payable only upon the return of capital. Management fees can be ramped down if capital is not returned within an acceptable time frame. Investors would be wise to build in the ability to take investments in-kind or to transfer the asset management if necessary.
- Recognize your own biases. Investing in co-investments comes with a certain caché. Who doesn’t want to be the one who invested in the big restructuring or pre-IPO that quintupled in value? To tell the story about how savvy they were to see in plain sight what the rest of the market overlooked? Everybody wants to be able to say they were right when everyone else was wrong. As a way of combatting this, incorporate independent and objective external parties to assess the deal and/or your analysis.
- Be comfortable saying no. The investor will be all the wiser for having devoted time to understanding the nuances of a given market or an investment even when they end up passing on the opportunity. Investors who see and underwrite more deals will improve their assessment capabilities and in the long run will likely develop better programs as they avoid the pitfalls that can ruin a single deal and taint an overall investment program.
Investors who keep the above principles in mind will have the right mindset for answering the five sets of questions below.
- Why does the opportunity exist in the first place? Put another way, why is there an opportunity to make outsized returns in what normally functions as an efficient global market? This is critical for any investment but is highlighted for co-invests due to their concentration, potentially higher volatility, and lower liquidity characteristics. Related to this, why does the offering manager have access to the opportunity when others do not? Investors should assess whether the investment has been subject to adverse selection—that other managers have already passed on the investment or other investors are not willing to invest at the terms the offering manager is proposing to engage in.
- Why is a co-investment structure necessary? What exactly is it that requires locked up capital? It is important for investors to understand why the investment being shown to them is not subject to adverse selection bias in terms of the offering manager choosing to market it instead of taking all of the exposure within their main fund. Lock-ups are great for managers, but that doesn’t make them necessary for investors. Could the manager have made the position larger within their flagship fund but chose not to?
- What is the pathway to value realization? Realized income or cash flows should be given considerably more value by the investor when analyzing a co-investment’s merits. How exactly will the investment bear out? Is there a catalyst whose timing is known and what is the game plan following that catalyst to exit whether the asset value does or does not react as expected? Managers often hold onto investments for longer to keep assets or if they are underwater in hopes of being proven right. Are there price targets? Is the realization of value subject to the market “getting it”? Relying on the market to change its assessment of a security is not a particularly good candidate for co-investment.
- What is the bear case? A good rule of thumb is to take the manager’s base case, and underwrite that as the bull case. What happens if the market “doesn’t get it”? What happens if certain assumptions break down? Is the worst possible outcome manageable? It is wise to avoid binary outcomes. Can somebody else manage the position if necessary? What mechanisms are in place to force the manager to return capital?
- Who else is in the deal with you? What other parties are critical to the investment’s success? What are their motivations and expectations? What are the liquidity terms of these other investors? Who is on the other side and does the opposing view have any merit? Relying on bankruptcy judges or government agencies to act in a certain way can be extremely risky as hedge fund managers do not always make the best assessments on how other parties, particularly those with non-investment motivations, will act.
We have seen an uptick in co-investment activity over the past several years. The increase in activity does not necessarily imply an increase in return opportunity but perhaps more of a business opportunity for managers looking to attract coveted locked-up capital. Nevertheless, the co-investment vehicle can be an attractive tool for investors to use to augment their returns. However, co-investments are not a requirement to build a strong portfolio and bring with them a unique set of risks that require extra attention. As with all investments, the motto “Caveat Emptor” (“let the buyer beware”) should be front and center in evaluating the merits of a co-investment.
Andrew Ross, CFA, CQF, FRM, CAIA is an Associate Director working in Portfolio Management, focusing on portfolio construction. He is actively involved in strategy and asset allocation for the firm’s flagship Moderate Multi-Strategy portfolios and serves as a portfolio manager on multiple custom account mandates.
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