The Case for Co-investments

Since the second half of 2022, we have seen notable growth in the number of co-investment opportunities crossing our desk: invitations from private equity fund managers to make direct minority investments in individual companies, alongside the manager’s private equity fund.

That is happening even as overall private equity transaction value has been falling: In the first six months of 2023, it was down 30% from the same period last year, according to PitchBook.

We believe the explanation is that general partners’ (GPs) demand for co-investment capital is growing, and it is meeting lower supply of capital from a smaller number of co-investors.

Does that mean the current environment for co-investments is particularly attractive? We believe so, and here we explain why.

Boost

Higher demand for co-investment capital reflects several things, including the increased need for equity financing as the cost of debt has risen and the general availability of debt financing has tightened.

In addition, it is a more difficult environment for private equity fundraising. That is leading to some delayed fund launches and potentially smaller fund sizes than anticipated. This, in turn, is leading GPs to seek to preserve dry powder—and using co-investment capital to complete some transactions can be an attractive solution.

We have observed that this market environment is giving a boost to “midlife” co-investments, in particular.

A midlife investment is a direct investment into a company that is already held by a private equity fund. These investments sometimes occur many years after the sponsor made the original investment. With IPO markets and other exit routes largely closed, and overall distributions from private equity funds down substantially, GPs are seeking other ways to generate liquidity for limited partners (LPs). The capital from a midlife co-investor can do this while allowing the GP to maintain majority ownership and control of prized assets, as well as maintaining their existing (more attractive) debt capital structures. GPs also generally seek midlife co-investment to go on the offensive, by pursuing an acquisition or an entry into a new market at a time when it is difficult to raise debt financing.

Our own observations suggest that midlife co-investment deal flow for the second half of the year rose almost 60% between 2021 and 2022, and over 80% in the first half of 2023, relative to the same period last year.

Capital Constraint

That helps explain the high demand for capital. Why is it meeting lower supply of co-investors?

One reason is that some of the more casual co-investment participants that have emerged in the past decade are stepping back now that the economic outlook is uncertain.

At the same time, because sellers of companies are demanding certainty around financing, GPs are, in turn, looking for more certainty of capital in the execution of transactions—which is leading them back to relying on their most trusted, core co-investment partners, who have invested across multiple cycles.

But the bigger factor is the “denominator effect” and related causes of capital constraint: Many investors have seen the proportion of their portfolio allocated to private equity rise as public-market asset valuations have fallen and private equity distributions have declined. This has left them with little ability to increase overall private equity exposure.

This is an issue for private markets as a whole, but we think it disproportionately affects supply of capital for co-investments, as limiting co-investment deployment is an easy way for LPs to lower additional private equity exposure while maintaining existing GP relationships.

Opportunity for Seasoned Investors

We believe these technical dynamics have provided an increase in the opportunity set for experienced co-investors.

In our view, discipline and patience is important in the current environment, but for investors with well-established GP relationships, proven deal-sourcing capabilities, experienced investment teams and the ability to execute midlife transactions, we believe economic uncertainty, dislocated financing markets and scarcity of capital is opening up a notable window of co-investment opportunity.