Commentary: Overcoming the 4 most common co-investment obstacles

The volume of co-investment deals has more than doubled in the past seven years to more than $104 billion, according to McKinsey & Co. As these opportunities continue to grow and claim a larger percentage of capital deployed, investors will feel greater pressure to optimize the due diligence process. The goal is a process that is both efficient and thorough in order to respond in a timely fashion and ensure the individual and collective co-investments are driving portfolio value.

With all of the focus on the growing opportunity, the challenges of creating and implementing the right process are too frequently overlooked. However, these issues are critical to co-investment success.

Here are the main challenges that demand limited partners develop a more thoughtful co-investment program to clearly separate the strategy's benefits from its risks and ensure consistency with firmwide investment principles:

Co-investments provide an opportunity to capture a greater share of attractive investments, and a large majority of investors find co-investments perform better than primary fund investments.

At the same time, co-investments also provide a broader dispersion of outcomes — offering outsized potential to add either significant risk or greater returns — compared to fund investing. This dispersion can be amplified within a portfolio and create idiosyncratic exposures if co-investment deals are over- or opportunistically weighted.

For example, co-investments are often the largest deals of the manager's fund, but not necessarily the highest quality deals. An investor might inadvertently be paying up for an opportunity that could overweight a portfolio in favor of large-cap investments and also greater capital loss risk.

Equally weighting each co-investment opportunity is a thoughtful and easy to implement mechanism that provides optimal exposure and a measure of protection against that dispersion. Anecdotally, we have found that an equally weighted portfolio also generally outperforms a portfolio that opportunistically sizes investments.

Further, equally weighting co-investments sets a standard within the program, improving the conviction in the opportunity and efficiency to which they are analyzed. Once this standard is set, managers can have more conviction that investors are the right partners for the opportunity and the investors can have the confidence that they will be presented with opportunities that are a better fit.

Importantly, some of the best co-investment opportunities are those that move the fastest, potentially ranging anywhere from months to just five days. Managers and investors alike never strive to leave a quality co-investment opportunity on the table — leading to a premium on due diligence efficiency.

An intuitive co-investment approach looks at the motivations of the managers presenting the opportunity. Are they shopping the opportunity as a marketing tool to entice future investor commitments? Are they offering the opportunity purely because they believe a broader opportunity set is what investors desire? Are the investments offered the best opportunities available to the manager? These questions and concerns about motivations are why investors choose to co-invest primarily with existing managers.

Additional conflicts of alignment can occur if a manager is offering co-investment opportunities without regard for the share of capital invested or governance of the portfolio company. A thoughtful co-investment program prioritizes opportunities where the manager has significant capital invested alongside that of the investors. This capital alignment provides the manager with appropriate incentive to drive value in the company for the fund and co-investors.

In a world of increasing co-investment demand, some managers offer opportunities within their portfolios without regard to their conviction in the opportunity. Whether it is because they are actively looking to develop new relationships with investors or looking to chase the latest hot sector, these elements of style drift — managers venturing outside their areas of industry expertise or preferred geographic zones — can destroy the benefits of this type of transaction and add significant risk to an investor's overall portfolio. Therefore, it is not surprising that many disappointing co-investment outcomes occur when there is a dimension of style drift.

A disciplined co-investment model will first focus on the manager's depth of expertise or track record in the industry, business model, and/or geography of the target portfolio company. Second, it will perform due diligence on the deal profile as compared to the manager's prototypical deal, providing a reference point as a guardrail against style drift.

A key driver of a successful co-investment program is the idea that co-investing is less about the sector, size of the deal or even the fee break and more about an investor's conviction in the manager and the quality of the asset. This principle and the two-step process outlined help to focus the opportunity set and lead to more consistent successful co-investment outcomes.

As noted, co-investing is a time- and resource-intensive process and investors generally have a narrow window of time to assess the opportunity. This resource burden can be an obstacle for subscale or undefined co-investment programs. Remember that relationships with managers are at stake when analyzing potential co-investments, and that a thoughtful and prompt response is needed to each opportunity.

An ideal co-investment program is efficient in analyzing opportunities because it is clearly defined and aligned with the firm's investment philosophy. It also leverages existing manager relationships and knowledge of the manager's strengths and weaknesses.

Finally, it is important that investors who are serious about developing a meaningful program build co-investment infrastructure with sufficient resources and staff with diligence expertise. A program can be staffed using internal professionals along with a third-party adviser or by creating a separate account vehicle with a dedicated co-investment manager.

As co-investing builds to a major part of both manager and investor playbooks, a disciplined due diligence process becomes paramount. Operational elements of this process are unique from investor to investor, but two principles are key to the foundation: commit to finding the highest quality asset and have full conviction in the talent of the manager.

One of the largest complaints by fund managers is that investors lack the programmatic approach to execute on available co-investment opportunities. By beginning with these four issues — sizing, interest alignment, style drift and resource commitment — in mind, investors can build a co-investment program that is not only efficient, but that will help deliver value to the portfolio.

Larry Kochard is chief investment officer of Makena Capital Management, Menlo Park, Calif. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.