The Rise of Increased Collaboration and Co-Investment in the Investment World

The investment landscape has witnessed a growing trend towards increased collaboration and co-investment among investors, fund managers, and institutions in recent years. This collaborative approach has transformed traditional investment strategies, fostering partnerships that leverage collective expertise, resources, and capital. As the market continues to evolve, understanding the benefits and dynamics of co-investment funds becomes essential for investors seeking to optimize their portfolios.

Co-investment is a strategy where multiple investors come together to invest in a particular asset or project. This collaborative approach allows investors to pool their resources, share risks, and gain access to investment opportunities that might be beyond the reach of a single investor. Co-investment funds enable investors to directly invest alongside private equity firms in specific deals. Unlike traditional private equity funds, where investors pool their capital and leave the decision-making to the fund managers, co-investment funds offer a more hands-on approach. This hands-on approach includes, but is not limited to, structuring, negotiating, and managing the investments. Co-investment can occur across various asset classes, including private equity, real estate, infrastructure, and venture capital.

Economic conditions, specifically rising interest rates, have significantly influenced the private equity landscape. Given higher purchase prices and reduced debt levels, closing deals now necessitates more equity than five years ago. Co-investment funds offer the flexibility to adapt to changing market dynamics, making them an attractive option. According to the Middle Market Pitchbook 2024 Q1 Report, increased interest rates and fluctuating valuations have dampened M&A activity over the past two years. However, sellers are now adapting to the new norm of lower valuations, which could facilitate more exits in the middle market in 2024.¹ With more opportunities coming to the middle market space, there is more opportunity for co-investment funds. A recent 2023 Goldman Sachs study among alternative investment limited partners (LPs) stated that 51% of LPs believe they are under-allocated in co-investments and plan to increase their allocations over the next couple of years.²

Offering co-investment opportunities enables fund managers to foster goodwill and demonstrate their expertise to both current and potential LPs. Fund managers can extend their reach beyond their current legacy funds’ capital through co-investments. This creates added incentives for the fund managers, which should result in LPs gaining better access to high-quality investment opportunities. Other significant advantages of co-investment funds for LPs include the reduction in fees. Traditional private equity funds typically charge a management fee and a performance fee. In contrast, co-investments often come with little to no management fees and reduced performance fees. This cost efficiency is particularly appealing to investors looking to optimize their returns.

The obstacles include conducting due diligence and managing co-investments, which require significant time and resources. Investors need to have the expertise and capacity to evaluate deals thoroughly. This can be a barrier for smaller institutions or those with limited investment teams. While co-investments offer higher potential returns, they also come with higher risk. Investors are exposed to the specific risks of the individual asset they are investing in, as opposed to the diversified risk in a traditional fund.

Further, the co-investment is not part of the main fund and will not be subject to the independent financial statement audit that the fund undergoes. Proper risk assessment and management are crucial to mitigate potential downsides and losses. Ensuring alignment of interests between the fund managers and co-investors can be challenging. Clear communication and robust agreements are essential to ensure that all parties work towards the same objectives and minimize conflicts of interest.

By pooling resources, sharing risks, and leveraging collective expertise, co-investment investors can access larger deals and forge strategic partnerships. However, successful co-investment necessitates thorough due diligence, ongoing monitoring, legal compliance, and strong governance. As the market evolves, embracing collaboration and co-investment can serve as a powerful strategy for investors aiming to navigate the complexities of the modern investment landscape.

Sources

1. Pitchbook: Q1 2024 US PE Breakdown
2. 2023 Goldman Sachs Asset Management Alts Survey