Attracted by enhanced returns, reduced costs, and greater control over portfolio management, LPs have increasingly allocated portions of their private equity portfolios to co-investments, often reserving 15–30% of their total private investment allocation for these opportunities. Despite broader challenges in the private equity landscape, institutional investors remain bullish about co-investments. According to PEI’s LP 2024 Perspectives Survey, 67% of LPs plan to engage in private equity co-investments within the next 12-18 months.
And it’s not just LPs showing enthusiasm. Amid rising debt financing costs, constrained liquidity, and fundraising challenges, GPs are turning to co-investment capital to fund larger equity contributions and strengthen investor relationships. Together, LPs’ appetite for co-investments and GPs’ challenges in the current dealmaking landscape have buoyed co-investment activity. However, despite steady deal flow, macroeconomic factors are reshaping deal opportunities and the necessary skill sets for proper assessment.
In 2022, debt financing became significantly more expensive as interest rates surged and traditional banks scaled back lending. Credit officers became empowered to impose stricter requirements on deals, resulting in enhanced demand for larger equity contributions. As sponsors have to write larger checks, co-investment capital has emerged as a welcome tool to secure transaction execution and bypass debt markets for capital.
Further, while rate cuts are anticipated by the end of the year, these dynamics could continue to shape dealmaking in the near and possibly long term. Rates may come down, but the tailwinds from the ZIRP era are gone. Pricier debt is likely here to stay, and as capital structures lean more on equity, co-investments will remain a favorable financing outlet.
By providing fee-free and carry-reduced opportunities to LPs, GPs can deepen LP relationships, giving them a competitive advantage amid a herd of firms vying for commitments. Additionally, fund closing times have lengthened, launches are delayed, and some firms are closing with smaller fund sizes than initially targeted. This has led many GPs to look for ways to preserve dry powder and control capital deployment and depletion from their main funds, with many using co-investment capital to stretch the runways of their own cash while still pursuing attractive deals.
Traditionally, most buyout co-investments involve a private equity firm and one of its limited partners investing concurrently into a new platform company. Today, amid constrained liquidity and expensive debt, ‘mid-life’ co-investments have gained popularity, playing an important role in helping GPs access company financing, fund growth, and generate liquidity.
In recent months, traditional exit routes like IPOs and sponsor-to-sponsor transactions have largely been unfriendly liquidity avenues for GPs. Meanwhile, LPs, dealing with a prolonged period of negative cash flows, are pressuring GPs to generate DPI. Yet, selling in the current market isn’t ideal for GPs, as they can’t secure prices at their desired multiple, prompting them to explore innovative liquidity options. Mid-life co-investments — alongside NAV loans and secondaries — have emerged as a valuable liquidity tool. In these ‘liquidity-based’ co-investment transactions, GPs crystalize a portion of the value that exists in a portfolio company by allowing LPs to acquire a minority stake.
As firms have to put down higher quantums of equity, they have to get more comfortable underwriting to value creation, which is causing many to take a cautious approach to acquiring new assets. In the current environment, doubling down on existing bets by compounding value in standout companies, where a GP intimately understands the management team and operations, has become a preferred route to conducting due diligence and backing a company where the value creation plan has to start from square one.
However, GPs that bought platform companies at the height of the market face a starkly different environment than when they were acquired. Financing costs have roughly doubled from what investors forecasted in 2020 and 2021, creating strong headwinds for companies servicing their debt and trying to achieve growth targets. With more of a company’s cash going towards interest payments, add-on capital has become an attractive outlet for funding acquisitions or organic growth. Yet, GPs looking to access capital face very expensive loans.
Here, mid-life co-invests have surfaced as a welcomed source for funding growth initiatives, as they allow GPs to preserve existing capital structures, keep favorable debt packages, and maintain majority ownership without involving a syndicate of other GPs.
LPs have long been drawn to co-investments for their potential to enhance returns and reduce fees. However, managing these opportunities is not without its challenges, and like GPs, many are also grappling with repercussions from current market conditions that color their perspective on co-investment opportunities.
LPs facing a lack of distributions or overallocation concerns may be less inclined to take on additional, concentrated private equity exposure, especially via co-investments — one of the few active measures they can use to adjust their private equity portfolios. Additionally, as GPs pursue various liquidity avenues, the lines between continuation funds and co-investments continue to blur. From an allocation perspective, assessing and categorizing these opportunities becomes difficult as they’ve started to overlap in both alignment and concentration risks.
As LP co-investors who were typically active in post-signing deal syndications have scaled back, GPs increasingly favor LPs who can underwrite deals. Yet, from an allocator perspective, these opportunities assume the most risk and resources.
The growth of mid-life co-investment opportunities has also surfaced unique considerations. In these scenarios, LPs may come in at a markup to the GP’s original entry point, and potential misalignment in valuation and exit can arise. This requires comprehensive due diligence, evaluating a private equity firm’s track record with the value creation plan and assessing its compatibility with the company’s existing debt structure. Ultimately, experienced investment professionals who can conduct robust analyses and model their own valuations are best positioned to make well-informed opinions on whether additional capital will yield meaningful results for a portfolio company.
Additionally, similar to a continuation fund, these opportunities can be advantageous. These assets aren’t strangers to LPs, and those with effective portfolio monitoring certainly can assess these opportunities on informed footing. Again, given that these transactions come without the fees of continuation funds, this additional work may be well worth the effort.
Downturn vintages tend to yield attractive returns. Funds launched in the wake of previous economic troughs, like the Global Financial Crisis and the Dot-com bubble, are among some of private equity’s top performers. This trend suggests that vintages following the 2021 economic dip could provide attractive investment opportunities across all private market sectors, including co-investments.
Further, amid volatility, co-investment dealmaking processes have swung in favor of buyers. With reduced time constraints, investors have ample opportunity for thorough due diligence, aided by improved access to information and management teams. These dynamics provide a fertile ground for co-investors to make high-conviction decisions.
As the landscape evolves, LPs adopting a more active strategy across co-investments and directs must effectively toggle the line between LP and GPs. While understanding strategy performance, concentration, and exposures is crucial for allocators, they also need the capability to conduct deep due diligence, model their own valuations, and assess portfolio company-level reporting as active stakeholders in individual assets.
Further, as GPs increasingly prefer co-underwriters, robust processes and infrastructure to support a co-investment program with the necessary granularity are essential for securing favorable deal flow. Here, robust technology infrastructure provides an invaluable tool for streamlining co-investment strategies.
Request a demo to learn how Chronograph allows LPs to seamlessly aggregate co-investment exposures, create quarterly valuations, and more.
Get updates in your inbox
Learn how Chronograph can streamline your private capital investment monitoring and diligence