Co-investment programmes have a substantial risk of generating poor returns, even with a reasonably sized co-investment portfolio, according to a study by Altius Associates.
Altius’ study empirically examines the risk of building a concentrated portfolio of private equity co-investments.
Using a sample of 886 realised US buyout and growth investments ranging from 1979 to 2010, it shows that with a co-investment portfolio comprising 10 assets there is a substantial probability that the entire portfolio would generate an IRR below zero per cent.
Furthermore, even with a 20-company co-investment portfolio it is still possible to lose significant capital as measured by either IRR or multiples.
Author of the study, Dr William Charlton, head of Americas investment at Altius, says: “As with most aspects of private equity, selectivity is one of the most important components of driving returns for investors. But even with good choices, co-investment portfolios may be subject to additional risk due to the impact, positively or negatively, of a small number of transactions in the portfolio.”
Based on a 10-company co-investment portfolio the study found that growth funds do not generate an attractive return profile under any circumstances with the average IRR measuring -8.1 per cent. Conversely, a 10-company buyout fund co-investment portfolio produced an average IRR of 14.2 per cent. The one bright spot for transactions is that they produced a significantly higher maximum multiple of 14.2x compared to the buyout maximum of 8.7x. However Altius warns that the dispersion of returns indicates that there is a probability that the returns could be poor, even across an entire portfolio.
Increasingly institutional investors are attracted to establishing or expanding co-investment programmes for a number of reasons including: avoiding annual management fees; capturing the full upside by not paying carry; mitigation of the “J” curve phenomena; immediate deployment of capital; and control of investment / sector exposure. While there are clear benefits for both LPs and GPs to participate in co-investments, Altius’s research revealed two inherent risks:
– Adverse selection: GPs may have an incentive to keep the highest expected return investments wholly within the fund structure. By doing so they increase their personal benefit by uplifting the amount of return that is subject to carry. Additionally adverse selection may occur when funds offer co-investment in deals that exceed fund capacity, which may put the fund manager in a market segment for which past returns are not representative and are more uncertain
– Portfolio concentration: LPs usually only invest in a subset of a manager’s portfolio and this may lead to an over-concentration of investment into a small number of companies
Charlton says: “While there may be important strategic reasons for institutional investors to establish or expand co-investment programs, care should be exercised to avoid the issues of intentional or unintentional adverse selection. Even if adverse selection can be avoided, there should be an appreciation for the nature of the risk inherent in a portfolio that contains a small number of risky investments that are likely to be highly correlated.”
