Institutional Investors Co-Investment

Institutional Investors Co-Investment

Thinking Man Series #39

Over the last few years, we have been building up our clients’ allocation to private investments.  BigSur believes that traditional asset classes (stocks, bonds, cash) will have lower performance going forward and that “non-traditional” and illiquid asset classes offer investors intrinsic value, especially in a QE world, where easy money has significantly inflated prices of liquid assets.  In our Thinking Man #22, published in September 2014, we explored this concept and analyzed five of the largest global banks’ return expectations on different assets classes.  Across the board, we found equity return forecasts over the next 5 years to be between 5-7% per annum and high grade bonds forecasted to return 1-2% per annum.  Using this information and a financial model, our Investment Committee estimated that a traditional portfolio with no “non-traditional” exposure would likely return around 4-5% per annum over the next 10 years vs. 6-7% per annum for a portfolio with 15-25% exposure to “non-traditional” assets.  

Over the last few years, we have studied “non-traditional” assets and also the strategies, allocations and investments of high quality institutional investors (i.e. sovereign wealth funds, endowments and pensions), who have been investing in these types of assets for decades.  In the last few years, co-investments have become an increasingly important part of these large and sophisticated investors’ portfolios.  On the spectrum of “non-traditional” assets, co-investments offer outsized return potential, making them an interesting asset type to evaluate for our client portfolios. In this month’s Thinking Man, we go through a Q&A on co-investing. 

What are co-investments?

A co-investment is a minority investment made directly into an operating company, alongside a financial sponsor or other private equity investor in a leveraged buyout, recapitalization or growth capital transaction.

They are essentially direct investments made alongside a private equity or debt fund in one of the fund’s underlying investments.  These direct investments are typically offered to existing Limited Partners (LP) of the fund, who is invested to participate in the transaction by the General Partner (GP) of the private equity or debt partnership.  Effectively, the co-investing LP becomes a small minority investor in the transaction led by the GP.

Co-investment opportunities are usually offered by GPs to those significant and experienced LPs or investors that have contributed a significant amount of capital to the fund or prior funds.  Not every transaction that the fund makes may have a co-investment opportunity; these typically occur when the private equity fund cannot invest the full amount required in the transaction due to concentration or diversification restrictions. In other cases, the GP may know that LPs have appetite for co-investments, and if they know there is interest in a particular investment from LPs, may plan to size the transaction accordingly.

What are the benefits of co-investing?

Many institutional investors are looking to increase their allocation to co-investments/directs as these investment have shown higher returns than other typical buyout funds.  The below chart shows the return profile of co-investments in a study done by Cambridge Associates.  The average return spread between dedicated co-investment funds IRRs and general buyout fund IRRs has historically been significant, averaging about 24%, with a range from 7% to 67%.

Part of the higher returns of these investments is due to the fact that co-investments lower the aggregate fee burden to investors.  LPs typically do not pay a management fee (typically between 75 – 150bps) or a performance fee (typically between 10-15% on an 8% preferred hurdle) on co-investments.  Thus far, all of the private equity and debt managers BigSur invests with do not charge their LPs to co-invest.  Another benefit to co-investing is that the capital is immediately committed and drawn, which allows for an element of investment timing.  This allows investors to take advantages that came up opportunistically – and also better assess if they can take on additional exposure at a certain point in time, or to take on more exposure to a transaction they may have high conviction in.

Co-investing also offers LPs the opportunity to become better investors: through co-investing the investor may gain experience in structuring, monitoring, and exiting private equity or debt transactions.  All of these can help to better select private investments in the future.

Another key benefit of co-investing is collaboration.  When we co-invest alongside other institutional investors or significant families, we’ve notice more often than not, we share similar values.  There also seems to be a consistent group of top-tiered investors who have a history of co-investing alongside each other, similar to a “Club of Investors”.  Through some of our existing investments, we’ve started to join this “Club of Investors” and are sharing best practices with these top-tiered investors.  Overtime, through collaboration we can improve the quality of our access to deal flow.

Who is investing in co-investments?

The benefits of co-investing have led many of the most sophisticated and large institutional investors to make co-investments an important part of their strategy.  In a special report, “LP Appetite for Private Equity Co-Investments,” Preqin, the most extensive private equity data and research provider, put together information on the type and size of the investors who are making co-investments.  You can see from Charts 2 below that Family Offices are still very new to co-investing, only representing 3% of the participation.  Chart 3 shows that the majority of co-investments have been done by very large entities, which is largely attributed to the fact that the largest LPs often get the most access to deal flow.

Risks to Co-Investing

There are of course risks to co-investing.  One is the short time horizon that investors have to analyze the deal – most often, the GP shows several LPs the deal, and allocation is somewhat on a first come, first serve basis.  This leaves a two week or one month turnaround time for investors to analyze the opportunity.  For BigSur, this means that we will only co-invest with LPs that we have an “open book” policy – those that will share all of their own internal and proprietary due diligence materials and memos.  We don’t have the time or capacity to do this research ourselves; instead we leverage off of the expertise and extensive work that our GPs are doing.  They are the specialists in the space and they are often evaluating these deals for months at a time.

The timing of when an investor will be offered co-investments is often unpredictable, which can make building a co-investment strategy difficult.  Deal flow can be hot or cold – depending on several micro and macro factors.  A great co-investment may come at a time when cash flow is limited or deals may be scarce when there is an abundance of cash.  Taking this into consideration, we find it very important that investors use this as an opportunistic strategy – and not a core building block of a portfolio.

Finally, there is concentration risk when making co-investments.  Investors are taking exposure to individual deals, so there is lopsided risk on the upside and downside.  If a transaction does very well, it can generate outsized returns; if it does poorly, it can have a large negative impact.  What becomes very important then, is that the size of the investment is appropriate for the client’s portfolio and that the investors feel very comfortable with the particular co-investment they are investing in.

Conclusion: BigSur’s Strategy on Co-Investing

Part of our philosophy is to bring our client’s to the “cutting edge” of the investment industry, and also to track the best practices of top investors.  Given that co-investments have become a more important part of large and sophisticated investor’s strategy – and that we are working to get deal flow from institutional quality and top tier GPs that have an “open book” policy with us – we believe this is an opportunistic strategy that can add value to a client’s portfolio.

We have already been co-investing with large pension funds on the real estate side, and to date have invested in 11 transactions.  We have been evaluating a specific co-investment opportunity sourced by a private debt manager we invest with.  This represents our first non-real estate private opportunity.  We will likely close this transaction in the next weeks.

We are one of three co-investors in this transaction; the others are two of the largest US insurance companies (each managing hundreds of billions of dollars).  We are excited to be offered a co-investment alongside these LPs who are a much larger size and experience in co-investing.

In the end, we find ourselves getting good access to co-investment deal flow for a simple reason: we are good LPs and the GPs like us.  These deals are typically reserved for much larger investors.  So why do these GPs invite us?  Because BigSur is diligent with our follow up, ask questions that show depth and understanding of the opportunity, spend time getting to know the GPs on an on-going basis, and are quick to take action.  GPs usually justify our participation because we are often the only private wealth or family office investors in the roster of LPs for that specific manager, and many times, the only institution representing Latin American investors.  This is key differentiation of BigSur’s offering. 

Important Disclosures

This material is distributed for informational purposes only. The discussions and opinions in this article are for general information only, and are not intended to provide investment advice. While taken from sources deemed to be accurate, BigSur Wealth Management, LLC (“BigSur” or the “Adviser”) makes no representations about the accuracy of the information in the article or its appropriateness for any given situation. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements are now or will prove to be accurate or complete in any way. This article may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements. BigSur shall not be responsible for the consequences of reliance upon any opinion or statements contained herein, and expressly disclaim any liability, including incidental or consequential damages, arising from any errors or omissions.

Please note this material includes BigSur’s “Strategic Asset Views”, which seeks to identify and reflect the Adviser’s views (opinion) regarding the potential portfolio withstanding of various asset classes. When developing its Strategic Asset Views, BigSur analyzes numerous other factors related to the markets in general and to the implementation of any specific assets class and trading strategy should only be determined via assessing these factors with each individual client’s overall characteristics. Therefore; BigSur provides its Strategic Asset Views for information purposes and for client considerations and prior to any client taking actions based upon these views such activity should be discussed with your individual BigSur advisor accordingly. The companies discussed herein, are for illustrative purposes only and do not represent past or current recommendations by BigSur. This article is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific investor. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. Any securities or products referenced BigSur believes may present opportunities for appreciation over the subsequent time periods. BigSur closely monitors securities discussed and client portfolios and may make changes when warranted as a result of evolving market conditions. There can be no assurance that the securities and performance included or referenced in the article will remain the same and investment strategies, philosophies and allocation are subject to change without prior notice. Specific securities or companies identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed were or will be profitable. BigSur may change its views on these securities at any time. There is no guarantee that, should market conditions repeat, these securities will perform in the same way in the future. Any referenced securities and their respective returns reflect the reinvestment of income and dividends, but do not take into account trading costs, management fees, and any other applicable fees and expenses. Please refer to Part 2A of BigSur’s Form ADV for a complete description of fees and expenses. Actual client performance will vary based on a variety of factors, including account restrictions, guidelines, the timing of investments, and cash flows. Hypothetical performance results may have inherent limitations, some of which are described below. An investor’s actual return will be reduced by the advisory fees and any other expenses that may be incurred in the management of an investment advisory account.

The returns and references to the S&P 500 index are provided for informational purposes only. The S&P 500 Index is a market-capitalization weighted index containing the 500 most widely held companies chosen with respect to market size, liquidity, and industry. The index is calculated on a total return basis with dividends reinvested. In addition, the volatility and securities of the index may be materially different from an investor’s. The S&P 500 Index was selected and is referenced to allow for comparison of the performance of any referenced securities or overall market to that of a well-known and widely recognized index. Comparisons to indexes in this material have limitations because indexes have volatility and other material characteristics that may differ from the referenced strategy or security. Therefore, actual performance may differ substantially from the performance of any referenced index. Investors should be aware that the referenced benchmark funds may have a different composition, volatility, risk, investment philosophy, holding times, and/or other investment-related factors that may affect the benchmark funds’ ultimate performance results. Due to these differences, indexes should not be relied upon as an accurate measure of comparison and are for informational purposes only. Unless noted otherwise, all index returns are denominated in U.S. dollars.

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BigSur Wealth Management, LLC
1441 Brickell Avenue, Suite 1410
Miami, FL 33131
Office (Main): 305-740-6777 ext. 8006
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http://www.bigsurpartners.com

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