Co-investment quality

For those that work in PE or involved in advising PE funds, would be interested to hear whether you think when PE funds offer co-investments to their LPs whether those deals are of a lower "quality" (e.g. lower return expectation vs deals that the PE fund usually underwrites or perhaps higher risk because the PE firm is stretching itself on deal size). 

Comments (6)

 
  • Principal in AM - Other
Feb 22, 2021 - 10:32pm

You are getting at the question of whether there is adverse selection in co-investments. You can find academic studies that show both conclusions but most recent works lean towards saying the answer is 'No'. Intuitievely, as a practioner, I can say with very high confidence that there is no adverse selection in co-investments due to these reasons 1) a GP does not know ex-ante whether a deal is going to be a winner or loser, 2) a GP would mostly never do a deal it had less than full conviction in since it affects the carry they can run through the Fund's waterfall (slight caveats here on American vs European waterfalls) although some behavorial factors could affect this point, 3) even if a GP knew it was doing a mediocre deal, it is against their best interests to convince their fund investors to invest in the deal since it could potentially ruin LP relationships and make raising the next fund that much harder and 4) most LPs will screen for adverse selection in their investment decision making. 

 
  • Associate 2 in PE - LBOs
Feb 23, 2021 - 3:59am

Fully agree - would add 5) equity syndicated deals are more complex and carry more execution risk so unless you have full conviction you won't go through the additional hoops this brings

 
Feb 23, 2021 - 5:17am

All really solid reasons for why there shouldn't be adverse selection in deals. Thanks for sharing your experience in this. Just wonder if there are situations that the GP is unaware of their biases or stats that suggest the type of co-investment deals that should be avoided? 

For example, I understand on average the last deal in a fund generally doesn't perform as well the rest of the fund (it might still be a good performer but just not as good). I guess the behavioral explanation is the GP has usually raised the next fund. 

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