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). 

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Comments (16)

  • 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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  • Associate 3 in PE - LBOs
Feb 25, 2021 - 1:00pm

Typically have seen the co-invest pressure come from LPs trying to get around fees and less so GPs passing the hat for shitty deals.  Especially given the increase in dry powder at allocators/FoFs over the past 10 years, there is increased pressure to get capital out the door in whatever manner possible. 

  • Associate 1 in PE - Other
Mar 1, 2021 - 2:02pm

I would agree with all the above and add a few more as someone that has worked in PE/VC (direct and fund of fund) industry.

  • LPs incorporate adverse selection in their decision
  • Usually, the fund has hard concentration limits and the fund cannot invest in the company without going over that limit, so they will bring in LPs - better to have someone you know on the cap table. Also, the LPs will give their voting power to GPs which would allow them to control more with less equity.
    • Another case is when the GP can invest the whole deal amount but wants to reserve some capital for M&A or some other tactic.
  • LPs are monitoring (at least FoFs do) their fund and co-investments and the last thing the GP wants is to get a bad recommendation. The LP world is small.

That being said, I have seen a GP trying to pass on a bad deal to LPs - no LP signed up. 

  • Associate 1 in PE - Other
Mar 1, 2021 - 3:34pm

It was a combination of things.

  1. They were nearing the end of their existing fund so there was pressure (not external, but just greed in trying to collect more mgmt fees by increasing their AUM) to raise the next fund, so they wanted to quickly deploy the remaining capital.
  2. The entry valuation was too high even though the projected exit returns look good. We did not have faith in their ability to execute all the things to hit that return at that entry valuation. M&A was a big one, the target would be left with limited debt capacity and in a heavily consolidated industry with many larger players, it is hard to imagine the target acquiring high single-digit companies per year. 
  3. Another example of this (not for the deal I am discussing) is when GPs say that a boring industrials company will grow >20% top-line when there are no significant tailwinds and there is nothing exciting about their operating plan.

Also, I have seen the bad deals with either really bad PE firms or some really good ones. The bad PE firms  - they are not good investors so can't expect them to identify good deals / not intentional.

For the well-known ones, sometimes they get overconfident, and sometimes they do it because they can get away with it. E.g. If an MF partner wanted to do a shitty deal (for whatever reason) they can maybe put in 10-20% equity and go to smaller LPs (in terms of how much that LPs put into that MF's funds) and risk losing them because they can easily replace those LPs due to high demand.  

  • Associate 1 in PE - Other
Mar 1, 2021 - 3:37pm

Another pressure tactic is if a GP provided few good co-investments to LP A and then they need to do a shitty deal (for whatever reason) then they can try to pressure the LP into doing that deal as not investing could mean the GP does not provide good opportunities in the future.

What I have learned is that many GPs try to get away with as much as possible. LPs try to keep them in line but it's not always possible. But I guess that's everyone in finance.  

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