Private equity co-investing demands micro rigor and macro perspective
Successfully executing a co-investment strategy is relatively straightforward, but in no way is it easy to accomplish. Whereas direct investing involves the full range of private equity activities—from sourcing through exit planning, from firm strategy through all elements of executing value creation strategies—co-investing involves a more limited set of requirements. Robust sourcing and effective investment selection are the ingredients for success.
Rarely can co-investments be originated proactively; instead, a co-investment program is largely reactive, dependent on external private equity relationships for opportunities to participate in attractive transactions. Getting the decision right on a co-investment opportunity—participate or pass—is crucial. After all, once a co-investor commits, the outcome resides almost entirely in the hands of company management teams and their private equity sponsors.
What seasoned investors seek in co-investments never changes
When investors select co-investments, the three key criteria are:
1 Alignment between the sponsor and its co-investors and a strong match between the sponsor’s area of expertise and the company’s line of business—even a co-investment in a fully valued company can succeed if it’s executed alongside a sponsor with the specialization and skill required to take the business to the next level
2 Attractive company characteristics, such as consistent free cash flows, durable market positions, and stable earnings growth that balance multiple value creation levers with a measure of downside protection
3 Portfolio diversification, with representation from different sectors, sponsors, investment strategies, and risk exposures
Policy uncertainty is high globally—and climbing in the United States
U.S. and Global Economic Policy Uncertainty Indexes
Source: Economic Policy Uncertainty Index, Macrobond, Manulife Investment Management, September 12, 2022.
Macro themes should inform co-investment decisions
While investing on predictions isn’t prudent, understanding current economic, geopolitical, and capital market conditions is essential in optimizing investment selection. Fortunately, there’s no lack of data, economic assessments, commentary, and opinion. Large institutional investors can consult with their own economists, compare their views with other market analysts, and integrate conversations with general partners (GPs) in a private equity funds program. Often, live deal activity provides real-time data on market conditions; movements in credit spreads, borrowing terms, and leverage, for example, are important considerations that must be updated frequently through discovery across multiple firm resources and investment teams, including those that focus on credit. To illustrate the point, take the disconnect that’s emerged between broadly syndicated loans (BSLs) and middle market loans. Recent stress among BSLs juxtaposed with the comparative stability of direct middle market lending has been a co-investment underwriting consideration, biasing decisions toward smaller companies with lower leverage—particularly those with lower middle market club lending structures where terms and pricing remain borrower friendly. As we suspect with many other limited partners (LPs) and co-investors, successful investors relish the opportunity to absorb the assessments and opinions of a wide range of leading private equity firms, investing across the gamut of industry verticals, underlining the implications they draw for their investment strategy and approach. NASDAQ down double digits this quarter? What are Francisco Partners and Thoma Bravo saying about technology investing? Two quarters of negative GDP? How are American Industrial Partners and Brookfield responding in the industrial space?
Understanding current economic, geopolitical, and capital market conditions is essential in optimizing investment selection.
Ultimately, investors should aim to build portfolios assuming only risks that are execution related and controllable in nature—merger-and-acquisition integration, enterprise resource planning implementations, and other value creation strategies—while steering clear of risks than can’t be controlled, such as those tied to customer concentration, regulatory change, and commodity price swings. Business models poised for growth irrespective of economic conditions are always attractive, and they’re even more important today.
"Business models poised for growth irrespective of economic conditions are always attractive, and they’re even more important today."
Insight Global and Addison Group, for example, are two staffing businesses with large information technology (IT) practices. On the surface, staffing seems highly cyclical; however, a prior mezzanine investment in Insight identified a secular change in IT staffing over recent years, such that it’s no longer so cyclical. Performance through the global financial crisis and pandemic periods and first-hand knowledge of the industry and these companies were additional inputs that revealed the cyclicality was muted and manageable.
Credit, secondaries, and other adjacent markets provide crucial clues
Investors with a cross-discipline presence in direct lending, mezzanine, primary, and secondary markets can create an information edge in private equity co-investing. Such affiliated programs often yield great insight into sponsor capabilities, sector risks and trends, and relative valuation metrics. For instance, when participating in board meetings over the course of a junior credit investment as an observer alongside a particular sponsor, a would-be co-investor can learn a great deal about that sponsor’s level of engagement and ability to add value; such exposure directly informs an investor’s next co-investment opportunity with that firm. Additionally, with multiple GP relationships throughout its history, an investor can gain a greater understanding of how a business may be affected by an exogenous event by reaching out to a subset of those GPs to hear how their former or current investments in that sector were affected by that same event. And, by casting a wide net across underlying transactions in secondaries, private credit, and primary funds, an investor can develop a detailed view of key issues such as valuation, relative growth rates, and margin sustainability.
No longer limited to when an investment goes public, the co-investor now must often be an active participant in the exit decision.
An important dynamic for co-investing has emerged as GP-led secondaries have developed into a common private equity realization tool. Whereas in the past, most exits were dictated by drag rights embedded in co-invest agreements, now co-investors are often faced with a decision: “Do I sell? Or do I hold and roll the exposure into a continuation vehicle?” Such a decision isn’t uncommon for investors that are both LPs and co-investors. However, a multidiscipline investor can leverage additional inputs, including those from, say, its secondaries team. No longer limited to when an investment goes public, the co-investor now must often be an active participant in the exit decision and be able to draw on a variety of perspectives and multiple avenues of information to aid successful decision-making.
A discernable edge resides in GP selection
While most co-investors have no advantage in predicting the length of the business cycle or the amplitude of its peak or trough, they can demonstrate a discernable edge in choosing the best GPs with proven track records. A worthy co-investing objective is to build a diversified, resilient portfolio of investments that has a positively asymmetric set of expected return outcomes. If co-investors succeed in getting that right, the odds typically line up in their favor as they seek attractive investment returns regardless of how macro and market conditions play out.
Editor's note: Much of this material first appeared on October 3, 2022, in Buyouts.
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