Jeff Davis shares his thoughts on co-investment with Simon Meads of Financial News in the article, “More Investors Develop an Appetite for Co-Investment”

More Investors Develop an Appetite for Co-Investment  By Simon Meads

April 2015

When EQT bought hearing-aids maker Siemens Audiology Systems from the German engineering group last year it made an effort to share the deal some of its smaller investors.

The Swedish private equity firm called for 10 investors to put 10 million euros each into the EUR2.15 billion buyout, according to people familiar with the deal. They got a piece of the action alongside some of EQT’s larger backers and minority partner Santo Holding, the investment vehicle of the German Strüngmann family.

It was an unconventional approach in the booming co-investment market which recognized that small investors as well as large pension funds and sovereign wealth funds are increasingly after a portion of the deals private equity firms do.

Euro NoteEQT declined to comment on the Audiology deal, but all the data points to surging investor participation in similar ventures.

Some 77% of investors surveyed by data group Preqin last year were co-investing, while only 7% had no current plans to co-invest. A more recent study found that 56% of investors wanted to increase their activity in the sector.

“I would say co-investment is on the agenda for almost every investor,” said Christian Sinding, head of EQT Equity. “Some of the investors are really qualified and have a team, a strategy and an understanding. And others are still scratching the surface–they see there is a lot of activity out there and they don’t want to miss out.”

Since raising its sixth buyouts fund in 2011, EQT has put a member of its senior team in charge of its co-investment processes. That has helped the group understand the demands and capabilities of its investors, firm up EQT’s own co-investment strategy and match the right investors with the right deals.

(This article also appears in Private Equity News, a U.K. trade publication of Dow Jones & Co.)

As a result, the group has brought in almost EUR1 billion of co-investment on deals over the last two years.

Mr, Sinding said: “Our mindset has changed and EQT is now managing co-investment proactively. We are on top of it, we have a person managing it, and EQT is able to find really good opportunities, which are good for the funds and for the investors.”

Co-investment rose up the agenda in the wake of the financial crisis. Large private equity firms turned to their wealthiest investors for capital as banks cut off the supply of financing for deals. Such agreements enabled firms to stretch the remaining capital in their funds a little further and delay returning to the turbulent fundraising markets.

Investors, meanwhile, were glad of the opportunity to invest without hefty management fees and carried interest.

Now that fundraising and financing markets have eased, private equity firms are finding they cannot turn back the clock.

Investors want to put more capital into co-investments and are heaping demands on private equity firms that many are struggling to satisfy. That in turn is leading to some disgruntled investors and blunt discussions about future investments in private equity funds.

At a recent board meeting, Britt Harris, chief investment officer for the Teacher Retirement System of Texas, said the emerging influence of sovereign wealth funds is creating stiff competition and curtailing the roughly $132 billion pension fund’s ability to do large co-investment deals of $100 million or more.

Since the start of 2009, a fifth of all buyouts in the U.S.–the market that accounts for the lion’s share of private equity investment–have involved co-investment compared with less than 5% in the previous five years, according to private equity marketplace Palico.

That demand from investors both large and small is putting pressure on private equity firms to offer more deals.

Some firms that previously never offered co-investment deals are now doing so, said James Pitt, a partner in Lexington Partners’ co-investment group.

“It’s much higher up most general partners’ agendas today, so we are seeing continuing significant increases in deal flow, although undoubtedly there is more pressure on allocations,” said Mr. Pitt. “On certain deals, where before we might have expected to receive a larger percentage, there are now more co-investment mouths to feed.”

Booming co-investment demand is not limited to the big buyouts. It stretches into the mid-cap and small-cap deals, and can create headaches for managers of smaller funds.

U.K. buyout specialist ECI raised 500 million U.K. pounds for its 10th fund by September last year and made its first deal for the fund in February when it bought into car scheme provider Tusker.

The firm typically offers co-investment when the equity required for the deals exceeds 10% of its overall fund, which usually results in between one and three deals per fund of a dozen or more company buyouts.

In the interest of fairness, ECI would usually offer a potential co-investment to two investors, and then take the next suitable deal to another pair of investors.

Jeremy Lytle, investor relations partner at ECI, said: “It is a bit of a minefield, and for a general partner this is where demand outweighs supply. There is more and more demand for it. If you are established buyout fund like we are, you have to set expectations early.”

The last time ECI offered co-investment to its backers was two years ago.

But clear outlines don’t stop investors calling up and clamoring for more, or exerting pressure at fundraising time.

Side letters to limited partnership agreements have long existed as a means for general partners to privately cater for certain investors’ needs–like excusing a Middle East fund from investing in a deal for an alcoholic drinks maker for example. But increasingly they pledge “reasonable efforts” to offer co-investments, as large checks come with strings attached.

“General partners have found that they are now faced with investors who say they are willing to commit to fund, but want a commitment to see co-investment at a certain level,” said Neil Harper, private equity CIO at Morgan Stanley Alternative Investment Partners. “Most groups that are raising primary capital will have a big chunk, if not a majority, of their investors expressing interest in co-investment.”

That not only creates competition among investors for deals and the potential for dissatisfied customers who lose out, but could also put pressure on firms to go after bigger deals outside their normal investment remit.

It can also lead to bad decisions by investors who are drawn by the perceived reward of low fees for private equity returns, but end up with under-performing investments because they don’t have the underwriting skills or the resolve to turn down riskier deals based on sketchy investment theses.

A study into co-investments by seven large institutions between 1991 and 2011 by Harvard academics Josh Lerner and Victoria Ivashina, as well as Lily Fang at the Insead business school, found that those deals underperformed the corresponding fund investments. The reason, they suggested, was that firms sold their investors “lemons”–large or riskier deals that were more likely to turn out badly.

Yet despite the risks, there is no sign of the demand slowing. Groups like EQT and ECI are doing what they can to accommodate that appetite and keep investors on side.

At the same time they are attempting to pursue good deals that will yield strong returns for their funds, and ensure they continue to draw a steady stream of management fees and lucrative performance fees.

“The fund comes first and then what comes after is viewed as gravy,” said Jeff Davis, partner at placement agent Eaton Partners.

“But the demand for co-investment is contagious, it spreads. General partners used to say to investors we’ll give you a board seat. But that’s not the prize any more, the prize is co-investment.”

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