Co-investment: in good company

Q: What are the key drivers attracting LPs to the co-investment strategy?

Alexandre Motte (AM): LPs have a tough job at the moment. They need to invest in profitable assets while limiting risk because of the growing geopolitical uncertainty.
Co-investment funds support investors looking to limit risk because of their highly diversified nature. For example, our latest fund will invest across 60 portfolio companies, which are diversified by geography, industry and size.
The second attraction is the robust investment decision process, which is taken by two groups. First, the controlling shareholder, who invites us to assess the deal. Then, at Ardian, we bring our expertise and our network into the decision. We are highly selective in our approach and typically act on only one in ten investment proposals.
Of course, this doesn’t eliminate risk entirely. We can be wrong or the GP can be wrong, but that double layer reduces the risk of us both being wrong.
The third driver is fees and carry, which for co-investment funds are typically lower than in traditional private equity funds.

Q: What have been the key growth drivers for the strategy?

AM: The market is growing because both supply and demand are increasing. On the demand side, investor appetite for co-investments has been increasing over the last few years for the above reasons.
Where there have been more recent developments is on the supply side. GPs are increasingly integrating co-investment into their strategies; they’re not shy in asking LPs to commit additional amounts when signing deals. This is supported by more sophisticated investors now able to carry out co-investment deals.
It has long been the case for large-cap GPs to involve LPs in their deals, but we’re seeing this behaviour moving more recently to mid-cap houses.
This is great for GPs who might have been chasing a target company for several years but were previously unable to transact because the company grew out of their investment remit. Now, they have an ability to act on these deals by working with co-investment LPs.
It’s a very positive cycle: more supply and more demand, providing a win-win for GPs’ greater ability to transact, and for LPs looking to deploy more cash.

Q: Is there a limit to how far the co-investment strategy can grow?

AM: Co-investment remains a niche within private equity. Typically, a traditional private equity fund makes between 12 and 15 investments, and requires co-investors in two or three transactions. Co-investments are only there when a fund is making a larger investment, so it remains a niche; but that’s a nice place to be within a growing market.
Growth in this market is coming from more experience of co-investments and is also fuelled by two trends in the private capital market.
One is first time funds, or fundless sponsors; when a team spins out to set up their own private equity house and they need to build a track record as a new team. Co-investment is great for these situations, and this trend is increasing greatly.
Another driver is secondary co-investment; investing two or three years after the sponsor initially invests, typically to support a build-up. Or if the GP wants to sell 50% of their stake, they can do that through a co-investment rather than on the market.
At Ardian, we haven’t been actively targeting these sorts of deals because they’re more risky and we have enough dealflow from the traditional market. But we’re keeping an eye on these trends for the future.

Q: Given the recent explosion in popularity of co-investing, what are the dangers often overlooked? Surely at some point GPs will tire of foregoing management fees?

AM: There are indeed two challenges when it comes to co-investing.
The first challenge is to have enough experience to go through a crisis, which hopefully of course does not happen. When you make a co-investment, you take on the risk of direct investing and with that the potential failure of the company and related loss of money.
For us, with more than 100 co-investments done so far, we’ve seen almost all situations, including bankruptcies, which we have managed thanks to the team’s extensive expertise. However, if a less experienced investor suffers large losses through a co-investment then they may face a backlash from their backers for having taken such a risk.
The second challenge is that some managers start making investors pay for co-investments. The discussion around whether or not GPs should be charging for these deals is increasing. Charging for co-investments would change the model and appetite for these transactions.
As an LP, we have many reasons as to why we shouldn’t be charged. We’ve backed the fund and already pay fees, we help finance a transaction that the GP could not do alone otherwise, we bring our network and lots of other non-cash benefits to the table. For now, it really is a partnership, where we’re fully aligned and working to achieve the same return. However, if the market becomes more difficult, we could see some GPs making LPs pay.

Q: Do you expect more regulation of co-investments to ensure all LPs are treated fairly?

AM: Currently, the regulator requires managers to develop their own rules or processes for co-investments. They need to be able to evidence why they invited one LP rather than another, which is a good development in terms of fairer treatment.
We see more and more GPs now with a dedicated co-investment person within the Investor Relations department, who understands what each of their LPs prefer in terms of deals, sizes, type of involvement, and who manages the syndication process.
In reality, if a GP has the luxury of three months to syndicate a deal, then it will be a fluid process which will likely work well for all LPs. But if you only have three weeks with limited information because the process is competitive, then only a small number of LPs will be able to act, and that’s where we differentiate ourselves. When a GP is in a competitive situation then we should be ‘priority plus plus’ because we can handle the time sensitivity.

Q: In your opinion, what would be the most positive development for the co-investment market?

AM: For co-investment to be recognised and perceived as a value-add to transactions. That co-investors aren’t just bringing cash to the table, we’re also providing networks and expertise.
This is why it’s important for us to meet the portfolio company management teams when we co-invest. When you think about it, Ardian invests all around the world in companies from sectors ranging from healthcare to consumer and industrials. For instance, when we invest alongside a mid-market GP in Texas or in Spain, we expect the manager to know the company and the particulars of its market, but when it comes to expanding that company globally, we have the relevant network and the expertise.
Co-investment is about combining a GP’s focused knowledge with an LP’s broader proficiency. We want to do this more and more and for the unique advantages of these partnerships to be recognised.