My daughter is a Managing Director at Cambridge Associates (CA) in Boston and she told me about a study that CA had recently completed for its clients on strategies to leverage relationships with PE sponsors for “no fee, no carry” co-investment opportunities.
CA’s study shows a dramatic outperformance of “all in” co-investment strategies over the base fund performance in a majority of the vintage years they studied. This makes sense because almost all co-investment rights are free of fees and carried interest and should dramatically boost the host fund’s performance, but some of the other results of that study were surprising.
By way of background, LP’s can pursue co-investments with 4 separate approaches. You can invest in a Fund of Funds that has a small percentage of its investments in co-investments. FOF’s have low management fees and carried interest because they pay the host fund a full set of fees as well. You can also invest in funds whose sole strategy is to invest only in co-investment opportunities. These funds usually reveal a strong relationship between the fund manager and the PE sponsors. CA demonstrates that these strategies lag (not exceed) the host fund in 75% of the cases. The third strategy is to leverage an investment in a PE fund for the right to pick and choose co-investments in that same fund. Finally, some LPs leverage a PE sponsor relationship for direct investment chances.
All these strategies have predictable risk/return characteristics with the direct investment approach having the highest variability. The CA study confirms that the objective of eliminating “fee drag” quickly diverges from actual investment performance the more the LP exercises discretion. Accordingly, if a LP co-invests in all the sponsor deals it typically does better than when it cherry picks. When LP’s pursue direct investment opportunities they often experience a bad result.
Another interesting observation by CA is that the SEC may be ready to spoil a perfectly good thing for the most sophisticated LPs by mandating co-investment rights be available to all LPs. This sounds good, but somehow I do not see a $1.0 million LP investor picking the right opportunity as well as the $25.0 million institutional investor, especially an institution with industry or deal specific experience or an experienced advisor.
The search for yield/performance is causing everyone to look for an edge. Like every sure thing, the co-investment strategy comes with nuances and Cambridge Associates demonstrates for its families and institutions that there are few “sweet spots” in a popular and growing investment strategy.
We have seen a similar trend and a similar result. In 2004 we had a hybrid fund where certain family LPs committed to co-invest in ALL our transactions and other family LPs paid a larger management fee for the right to choose where they invested. What we observed was quite similar to the CA empirical analysis. Those who did all our deals in that 2004 fund did quite well and those who chose underperformed the committed group. As the GPs of that fund, we underwrote the non-participants, and we learned that, if you believe in the sponsor, as a co-investor you should be like a great Texas Hold’em player –ALL IN.
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