How to capitalise on co-investment opportunities

Co-investment can improve portfolio diversification, increase market insight and act as a driver of value:

Around 20% of all private equity deals by value were co-investments in 2015, SuperReturn Asia 2017 heard.

Myron Zhu, co-head of Private Equity Asia Pacific at Aberdeen Asset Management (AAM), said for him deciding whether or not to do a co-investment was all about economics.

He said: “As a manager we are increasingly looking to co-investment as a key driver for value.

“We view the co-investment process as the best way for us to do due diligence on the underlying fund managers.”

He said when AAM looked for a co-investment they favoured deals in the “middle of the fairway” where the general partner’s (GP) core competencies were.

He added that when successful GPs moved into marginal deals outside of their core areas they were more likely to make mistakes.

Zhu said AAM was very selective in the deals it did, and one of the key pitfalls of co-investment was that you needed to have enough capacity, as you often had only three to five weeks in which to make a decision.

But he added that smaller investors could still do co-investment if they had the right resources and core competencies.

Weichou Su, partner and head of Asia at StepStone Group, agreed that limited partners (LPs) ideally needed scale to do co-investments, as that enabled them to have widespread connections and GP relationships to generate the deal flow.

“We allocate USD20bn into funds each year and that generates a lot of touch points and that is important,” he said.

He added that LPs also needed to be flexible.

“If you can only do USD10m to USD15m that leads you to a certain type of co-investment and a certain type of deal. But if you have the tools to do different things, and we can do USD10m to USD300m, that gives the GP a lot of flexibility.”

He added that being local also has advantages, as it was important to have your own insights and not be a taker of every deal.

Informing market activities

Yup Kim, senior portfolio manager, special opportunities at Alaska Permanent Fund Corporation, said co-investment had helped to inform their primary market activities.

“You can engage in a much deeper way with the management teams you are involved with and really see your GP in action. It sets up intangible insights,” he said.

“You can also get closer to the valuation process. As you engage in more investment you can start building a network of senior managers and CEOs who can give you unfiltered feedback on various areas of interest.”

He added that he thinks there are several criteria that can help make co-investment successful.

Kim said it was very important to have a clear set of goals and objectives that you were trying to achieve with the co-investment programme.

Secondly, he said the process was important as co-investment was a relationship business and you needed to come to a decision quickly, and give very solid reasons if were saying no.

“If the no is not well validated, then the likelihood that the GP will come back to you with another co-investment is less,” he said.

Finally, he added that you needed to be very self-aware of your organisation’s strengths and weaknesses to be a value-added partner to your GP.

Increasing diversification

Yan Yang, director at BlackRock, said running a co-investment programme could add an additional layer of diversification to your portfolio.

“You not only have additional diversification on your geographic focus, but more often than not you also have diversification by GPs,” he said.

But he warned that the market was getting “extremely hot” and there were a lot of different forces competing for the same deal.

He added that during due diligence it was important not to completely trust the GP’s model.

“You want to validate their model and assumptions using your own resources.

“If you do all this homework and by the end of the day you still feel like it is a valid business case it will help you to make a better decision,” he said.

Yang also advised GPs looking to co-invest to pay attention to the quality of their model.

“We want to see a model that is without obvious errors. Every year we screen hundreds of different deals and you do see situations where there are mistakes in the model and that immediately gives you questions about their credibility,” he said.

He also stressed it was important for GPs to be realistic about their business forecast.

But Kim said the process of co-investing did get easier.

“The second co-investment that you do with GPs becomes materially easier than the first. You are able to identify the nuances and the process and understand the timetables under which the GPs are operating,” he said.

He added that around 80% of their deal flow came from only 20% of their GP relationships.