Differences between Co-invest and Secondaries?

APAE laughing_man Wow, thank you both for your responses - that was very helpful in having clear understanding of each strategy. I’m really interested in pursuing co-investments at SWF and Pension Funds after my banking analyst years.

Do you happen to know if there are any resources you could point me to better understand the distribution waterfall and return models for co-investments? I’m assuming it’s a bit different than the traditional LBO models, especially if co-investments are all in equity like growth equity investments. Will PM both of you in case that’s easier

Haha kind of hilarious that I got tagged alongside you because this blows any response I would've written out of the water.

One thing I will add is that family offices are a big player in all 3 - they're often less constrained in their mandate and can flexibly deploy capital as they see fit. Also, some LPs have a single team that handles all investments (may have specialization, but essentially one team), while others have distinct teams that are responsible for specific types of investments only - generally, this has to do with size and it's tough for like CPPIB to have one team do everything given how much capital they have to deploy every year, but it also comes down to investment philosophy and staffing model.

At my firm (a family office), fund investments form the core of our investment program, but we always look to seek out co-investment opportunities alongside our core partners, or selectively w/ partners we are not already invested in if we are trying to develop a relationship and become a potential LP in the future (or vice versa, if a GP wants us as an LP they might offer discount / fee-free co-invest even if we are not an existing investor). Big benefit of co-investments is that they often are fee-free / carry-free for LPs, so it's a great way to juice returns in high conviction investments. Investing with a partner that you are not an LP is often trickier, because there's often the question of why existing LPs are not taking the co-investment capacity in the first place.

Different LPs approach co-investments differently, with some basically just taking an IC memo from the GP and saying yes or no or even just setting up a blind pool co-invest account with the GP. But my team basically fully underwrites each co-investment ourselves, leveraging the GP's materials and research of course (take their existing model as a base and build on top of it / change assumptions as needed, review their QoE / consultant reports, etc.), but we make sure to form our own view on the investment and look to validate the base / upside / downside scenarios, tweaking as we see fit - this includes going through the entire model and changing things as needed, conducting our own reference calls, meetings / calls with both the GP and management team (if possible), running our own comps / valuation, reviewing the data room ourselves, etc.

As far as secondaries go, those are often tough because of adverse selection bias - basically, what's wrong with the portfolio that results in somebody wanting to sell it. Of course, there are totally valid reasons as to why this could be the case as mentioned above, but always something to be cognizant about. There are either secondary purchases of LP interests, or you can acquire a portfolio or select assets from GPs themselves. Sometimes a GP will have a "crown jewel" asset that they have high conviction in and want to keep holding it because they see significant continued growth potential or whatever (e.g. TPG's secondary sale of Creative Artists Agency) where that asset will be purchased from the fund and moved into a single-asset SPV just to hold that investment (with potential growth capital as part of the deal to grow the business even further). Secondaries very broadly speaking are becoming increasingly popular, with some very interesting variations of the model out there such as what Whitehorse Liquidity Partners is doing, effectively preferred equity for PE portfolios (instead of outright buying secondaries at like 85-90 cents on the $, they'll give the LP 67 cents on the dollar and take 100% of cash flows until they reach a certain return threshold, then the LP gets the majority of the upside and Whitehorse retains a smaller upside piece).

Something else to mention is GP stakes, where managers will acquire a minority interest in a GP itself - there are funds being raised out there to pursue this strategy exclusively (Dyal is a prominent name), but LPs themselves may also look to structure deals that involve GP stakes. This is often the case for newer managers to help get their firms up and running, and you could have an LP making a significant fund commitment but also acquiring 5% of the GP itself for example, in order to share in upside of the growth of the overall business. And of course there are many variations here as well, as it could be either in the overall GP at the management level, at the fund level (or specific type of funds only), be a carry share only or mgmt fee + carry).

For waterfalls, all you really need to do is take the existing model and then layer on the GP's fees / carry - no need to create a completely separate model if that's what you were thinking. Here's a good intro resource on how waterfalls work between GPs / LPs: https://www.asimplemodel.com/reference/65/distribution-waterfall/

APAE:

Fund-of-funds:

A fund-of-funds is a firm that raises a blind pool of capital just like any other investment fund, but instead of making equity or credit investments directly into companies or their publicly-traded securities, it invests capital into other funds.

The overarching business model is the same as a typical investment firm. The aim is to raise a fund every few years, and each fund has a predetermined investment period and harvest period.

The strategy can vary, however. Some fund-of-funds are multi-asset class: this means they diversify across hedge fund, long-only, private equity (buyout, growth, venture), real asset, and fixed income managers. Others specialize in a single asset class, focusing solely on one of the above.

Their fee model is lower, however. They aren't able to charge the "2 and 20" that direct fund managers charge, which makes intuitive sense. A Limited Partner doesn't want to pay 2-and-20 twice. Consequently, a fund-of-funds will usually try to negotiate a fee concession from the GPs they invest in and get them to go down to something like 1.5-and-15.

The sales pitch is that they will be 'sticky' capital (invest in multiple funds for your firm, won't leave easily like a family office might, for instance), that their check size is heftier than a typical LP, and that they will add credibility to your fundraise if you mention you have their commitment. In turn, they make their fee like 0.5-and-5, such that between the underlying GP's fee model and their own, the LP in the fund-of-funds is still only paying 2-and-20 or something marginally above it.

Secondaries:

A secondary firm raises a blind pool of capital and deploys it by purchasing existing LP interests in a fund from an LP who wants liquidity. You could classify them as a type of fund-of-funds.

For instance, say CALPERS or the NYS Common fund gets a new CIO. He or she decides they cannot stand venture capital, they think it's too risky and the return profile is unattractive. In their first month on the job they discover that their portfolio includes $5bn in commitments to 80 different VC funds.

Each of those funds is at a different stage in their lifecycle. A bunch are in the first or second year and therefore have barely begun deploying capital, meaning they haven't made many capital calls against the LP's commitment. Some are in the fourth or fifth year and therefore have deployed the majority of their capital but have not yet distributed returns to LPs. Some are in the eighth or ninth year and have distributed substantial returns to investors.

That's clearly a messy situation; the CIO's decision to get out of all those fund relationships can be quick, but actually making it happen isn't going to be quick at all. It can be a nightmare just trying to do all the math: liquidity analyses, return analyses, capital call scheduling, etc.

That's before you even get to the relationship management part where you have to alert the GPs involved, soothe their ego bruised by the idea that someone could possibly want anything other than to remain an investor in their firm, find a willing buyer, negotiate the GP's approval of that buyer (who will now be an investor the GP has to deal with instead of you), and finalize pricing terms and documentation with that buyer.

A secondary firm is a party who takes the effort to calculate the value of all those LP commitments, evaluating where they are in the capital call schedule, what portion of the commitment remains unfunded, and what kind of distributions have already been made. After that evaluation, they calculate a value for the LP commitment in that fund and make an offer to the existing LP (CALPERS/NYS Common in our example). CALPERS gets a lump sum payment for whatever LP relationship the secondary fund buys from them, and everyone is happy.

One note to make is that a lot of GPs have restrictive clauses in their subscription documents that limit whether or how LPs can transfer their commitments to another party in the secondary market. Not every GP is eager or open to the idea of someone they don't know now being an LP in their fund instead of the LP they already know and have a relationship with.

Co-investments:

Very often a private equity firm wants to pursue a deal that's larger than its fund size would safely allow it to. Illustratively, say a firm is investing out of a $1b fund. Say they follow a growth equity strategy, so they're not using leverage and they aren't making platform investments where they'll do bolt-on deals, so it's just going to be 20 deals that are about $50m each.

Say they find an amazing opportunity. A founder-owned business that was a bootstrapped startup where the guy never took venture capital, and 12 years later, has a very profitable and still scaling company presenting 30% net margins and 20% annual growth. He's looking to sell 10% of the company for $200m.

You can't put one-fifth of your entire fund into a single deal. At the same time, this deal has to get done. So you call around the Limited Partner universe trying to find a co-investor who will come in for $150m alongside your $50m. The LP did not commit to your fund, but they are participating in a specific deal with you.

There are a lot of structures that can follow. Sometimes you'll make an SPV (a Limited Partnership where you are the GP, you tender your $50m and they tender their $150m and you manage the entity) so you are in the same position of control managing the investment in the company. Some are very removed, where you invest separately from the co-investor and they're free to pursue liquidity with their position at any time.

There's no uniform way, so the economics can vary widely. Some GPs try to get full-freight fees on any co-investment (charge the LP 2-and-20 on any dollars deployed, regardless of whether it was through a fund commitment or a co-investment). Some GPs offer a concession, like 1-and-10. Still others will offer a fee-free co-investment model. In those cases it's usually about proving a track record at a larger check size than your current fund would tolerate, because that supports you asking for a significantly larger fund next time you're in the market.

For the record, this is why you often see such a significant jump between a firm's fund sizes. Sharp guys will come out of a place like Apollo or Carlyle and raise a $500m debut fund (fairly attainable with a decent track record, you can get that done within a year or so), then follow it up with a $1.5b Fund II. The casual reader might scratch their head, but the thing to read between the lines is that they probably deployed closer to a billion over that first fund's lifecycle thanks to co-investments.

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These three things are fairly intertwined so it's easy to be confused. Some secondaries shops will do co-investments as well. Sometimes it's a distinct business line, and in other cases it's opportunistic to react to deals presented by GPs whose funds they bought into through a secondary transaction. Fund-of-funds tend not to do co-investments, they are generally just allocators.

Co-investments are dominated by the big pensions and sovereigns. Typical names here are the APAC SWFs like GIC, Temasek, KIC, Mubadala, ADIA, etc. Interestingly, the Canadian guys like OTPP, CPPIB, and OMERS have been proactive in the past decade to begin building out stronger direct investment teams by hiring away great senior staff from the megafunds. What this usually indicates is that they want to get away from any fee layer a manager could charge, so co-investment activity may begin to scale down since they want to be acting on ideas of their own generation. It makes sense. A GP's gross return is now your own net return.

Secondaries have half a dozen prominent names. Strategic Partners leads the pack, they're a huge contributor to Blackstone's AUM growth. You mentioned Coller Capital. There's also Lexington Partners, Portfolio Advisors, GSAM (you don't see this strategy mentioned in the press much, but their fund size [$7b for the last one I heard] is three to five times the size of the prior two firms mentioned), Landmark Partners, Partners Group, Hamilton Lane ...

Many of those names bleed over into fund-of-funds as well. Ardian is the giant here, along with HarbourVest, LGT, Partners Group, Pantheon, NB Alternatives, Hamilton Lane, etc.

There are rankings available on industry resources like PEI.