Cheaper at the horizon. Interest rate hikes in the 2022 Fed tightening cycle, and subsequent bouts of public market corrections, precipitated a dip in private equity valuation multiples to 10.8x in 2023, down from the post-GFC (Global Financial Crisis) peak of 11.9x in 2022 – the first downward adjustment in more than a decade. Lower valuations such as these present attractive opportunities for buyers, offering not only cheaper entry points, but also the potential for internal rate of return (IRR) recovery when market conditions improve, especially as the Fed has embarked on a rate cutting cycle.

Co-investments to the fore. The prospect of amenable valuations and IRR uplift in private equity compels the careful selection of private equity access points to reap the most reward in a timely manner. While primary funds provide a foundational and diversified entry to private equity and are naturally the first access point that comes to mind, investors do not gain immediate exposure to underlying assets at prevailing market conditions due to early-stage expenses, and take longer to reach positive returns on committed capital.

Co-investments are spin-offs from the primary fund investing model and offer investors the opportunity to invest alongside General Partners (GPs) outside of the aforementioned primary fund commitment structure. Typically, GPs offering co-investments opportunities have already examined the underlying investments, negotiated the terms of the transactions, and are in the process of closing the investment, but require a larger check than they are momentarily able to write. Co-investors fill the funding gap, and in the process, ride on the GPs’ expertise in deal sourcing, due diligence, and diversification, at an attenuated fee compared to primary fund investors. This arrangement, however, only gets co-investors a minority stake in underlying target portfolio companies. Nevertheless, the arrangement confers co-investors the ability to accelerate their capital deployment into the asset class, and at the prevailing market conditions. Such control over private equity portfolio is paramount. When market environments are favourable, co-investments can be used to build private equity exposure quickly. When valuations become stretched, however, co-investors have the flexibility to taper deployment.

Outperformance more than meets the eye. A comparison of median net IRR of primary funds and co-investments highlight the outperformance of co-investments, which interestingly persisted across bouts of macroeconomic uncertainty since the GFC. The outperformance in net IRR over primary funds during key macroeconomic disruptions from 2017 to 2023, in particular, were in spite of rising private equity valuations, suggesting that the differentiating edge of co-investments likely goes beyond mere enhancements in deal selectivity.

The “fee” advantage. In contrast to primary funds which display a flat management fee and carried interest structure, co-investments show a dynamic management fee and carried interest profile which appears to adjust in response to macroeconomic conditions. At the dawn of the Covid-19 pandemic, carried interest for primary funds were fixed at 20% whereas that for co-investments were down-adjusted three-fold and reached 10%. Similarly, management fees for co-investments tapered down to 1% ahead of the 2022 Fed tightening cycle, whereas that of primary funds remain fixed at 2% (Figure 4). The stark differences in fees and carried interest between primary funds and co-investments during macroeconomic disruptions likely contributed significantly to the IRR disparities observed (Figure 3).

Lower fees pay off. To illustrate the impact of lower fees and carried interest on relative performance, we ran a hypothetical capital distribution model (Figure 5) fitted with median fee values (from Figure 4) under the assumption of 2.0x gross returns for both co-investment and primary funds over a seven-year horizon. The reduction in GP costs led to a 16% increase in net performance for the Limited Partner (LP) in the co-investment program.

All that glitters is gold. Having elucidated the role of lower fees on the outperformance of co-investments over primary funds, we proceeded to examine the downsides of co-investments by generating a probability distribution model of total value paid-in (TVPI) multiples based on 5,000 simulations of sample baskets containing co-investments and primary funds. The model reveals the probabilities of 5.3% and 10.9% for TVPI to dip below 1.00x in co-investments, and primary funds investing, respectively. This suggests that co-investments offer some downside attenuation compared to primary fund investments.

Making a foray into co-investments. Co-investing offers unique opportunities but also presents specific risks that investors must navigate carefully. Uncertainty in the deal pipeline often means that co-investors cannot predict the quality of upcoming deals. This necessitates well-resourced and experienced teams to conduct thorough evaluations as and when opportunities arise. Additionally, compressed response times for co-investments (often closing in a matter of days to weeks) increase the risk of inadequate due diligence. Investors need to be mindful to prioritise rigour above agility to uphold due diligence standards despite time constraints. Next, adverse selection – the risk of GPs offering less attractive deals to co-investors and reserving stronger opportunities for their flagship funds – can result in co-investors allocating disproportionately into deals with high chance of underperformance. This risk may be mitigated by working with reputable GPs who are motivated to offer quality deals to co-investors to foster meaningful long-term relationships. Finally, GPs vary widely in transparency and reporting practices. Working with GPs who are committed to providing comprehensive due diligence materials and consistent performance reporting is paramount.