Fundraising by private equity funds is under pressure – but co-investing alongside funds is gaining momentum. Peter Knight, Head of Co-investments explains what’s fueling demand for co-investment opportunities, and what that means for high net worth investors (HNWIs).
An interesting phenomenon is developing right now. At a time when fundraising for traditional private equity funds has shrunk, with 2022 seeing fewer than a third of the funds launched than in 2021[1], the pipeline for co-investments looks relatively healthy. Appetite for co-investment deals (where an investor invests alongside a private equity manager in a specific portfolio asset, rather than having to participate in a fund, which may also be making an investment in the asset) has been growing in recent years. So much so that commitments to dedicated co-investment funds totaled almost $27billion last year[2]. Here, we look at what’s driving this rise in co-investing and how private investors can benefit from this trend.
Filling the funding gap
The market turbulence of 2022 and its hangover has affected private equity fundraising. The impact of the denominator effect, capital calls to support existing investments with follow on funding, and ongoing volatility has meant a slowdown was inevitable. When times get tough, many institutional investors (the Limited Partners or LPs in a fund) tend to gravitate to the big-name fund brands, seeing them – rightly or wrongly – as the safest option. That means that while the largest private equity managers (also known as general partners or GPs) may remain comparatively insulated from the general market fall in fundraising, mid-market players, even those that are well-regarded and highly-performing in their space, will inevitably be significantly impacted.
This funding gap is being exacerbated by the fact that many debt providers are simultaneously retreating from the market, temporarily at least, as they re-assess their lending models or adjusting their underwriting requirements. Though there are signs that some lenders are now returning to the fray, the bottom line is that other sources of capital are required to meet funding requirements.
As a result of these shortfalls, deal sponsors are therefore far more likely to consider co-investing as a way of raising the capital they need. For investors like us who have access to these sorts of deals, and our private investor clients, strong demand is good news, providing a broader sweep of potential opportunities.
Another factor powering the growth of co-investment opportunities is an increase in secondaries activity. Whether GP or LP-led secondary, single asset vs portfolio deals, the number of secondaries deals has increased significantly in recent times with GP-led secondaries transaction volumes having roughly quintupled over the last five years and totalling $68billion[3] in 2021.
In large part this is a response to where we are in the cycle: on the one hand, GP and LPs want to stay with their most prized assets for longer, whilst they wait for a more favourable exit environment; whilst on the other hand liquidity pressures, particularly for LPs as they stare down the barrel of the dreaded denominator effect, are forcing people to bring secondaries deals to the table which we might not have otherwise seen in more benign times. In either scenario, it is very often the case that new, third-party capital is required to facilitate a degree of liquidity to existing holders of the assets which provides great opportunities to flexible co-investors such as ourselves.
Lastly, GPs are also being increasingly innovative. Those who have chosen to complete deals using their own capital during the recent challenging conditions are now looking to sell-down part of that position to co-investment partners. Some GPs are deciding not to raise a blind pool fund at all, choosing instead to become ‘fundless sponsors’ who raise all their capital on a deal-by-deal basis. Existing fundless sponsors are broadening their pool of capital providers, whilst new fund managers are using individual co-investments as a way to build their profile and track record before launching a fund. Again, all of this adds to the opportunity set, and plays well from an investor’s point of view.
The best of both worlds: selectivity and scale
Co-investing is about being selective and working alongside trusted partners. Co-investors can be strategic about which investments they want to make, choosing the best assets from fund portfolios to suit their own specific requirements. And in today’s environment especially, it pays to be picky, searching out the most robust businesses at the right valuations, and being opportunistic where appropriate.
It’s also about scale. For us, the rationale for co-investing is to give our clients access to deals that would normally be out of the reach of private individuals. The transactions we can participate in on a co-invest basis are typically larger (reaching into the upper-mid market space) than we target through our own direct investment deals (which tend to be in the lower mid-market) because the capital is drawn from a larger pool. Investors get the added comfort that the GP’s expertise and due diligence have been brought to bear, as well as our own.
Ultimately, co-investing is a hybrid of direct investing and fund investing, delivering the flexibility and choice of a direct approach, while enabling clients to participate in bigger deals alongside best-in-class fund managers. No wonder it’s so popular. With fundraising looking set to remain challenging for the foreseeable future, demand for co-investment capital is likely to stay strong. As more and more GPs and investors see the advantages, this is a market with plenty of potential for further growth.
[1] Source: S&P Global Market Intelligence, 6 January 2023 https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/fund-launches-cratered-in-2022-private-equity-s-share-of-terminated-deals-grows-73723322
[2] Source: Preqin, https://www.wsj.com/articles/co-investors-to-benefit-as-private-equity-capital-grows-scarce-11672958428
[3] Source: Jeffries Global Secondary Market Review. Data as of October 2022.