Professional private equity investing has long been associated with funds, but has not been left entirely untouched by this trend. Indeed, pooling capital offers three benefits: accessing and sharing a rare expertise, cost sharing among investors and risk diversification. Contrasting with this, direct investing in unlisted companies excludes delegating the investment decision itself. Doing so, however, and sourcing direct investment opportunities or analysing them is challenging for private investors. The reason is that private firms are often “below the radar”.

Such direct investing can therefore accommodate various levels of intermediation and involvement:

• Solo investing: a single investor takes the decision alone and provides all the required resources.
• Club deal: several investors share decisions and also the resources and tasks. Each investor can steer the process.
• Co-investing: typically there is a lead investor, sizeable and institutional. Single investors can tag along but do not influence the process.

Solo direct investing itself remains largely the realm of specialized investors, syndicating and pooling their investment opportunities themselves. Club deals started to change this perspective, with an acceleration in the middle of the last decade. Further pressure from investors to participate more passively led to co-investments. This paper will look to focus on this latter trend.

According to a Campden report[1], the typical direct allocation of European family offices increased from 5% in 2008 to 14% in 2014. In APAC, the figures were respectively 9% and 14%. A certain abundance of capital and talents, as well as a certain commoditization of private equity techniques created the conditions for such an evolution, which has accelerated since then. Co-investing currently represents 15% of private equity investments and 30% of amounts according to Pitchbook. This proportion is not expected to change materially in the future.

The motivation of co-investing differs from investor to investor: each of them differs in size, nature, level of expertise and degree of involvement, as well as expected risk-adjusted returns. Some investors might also have non-financial objectives. The following objectives are usually associated with co-investing.

Generating returns

The first motivation is to enhance returns. Co-investments potentially increase net performance by helping investors reduce (in case of co-investing along funds) or eliminate (when bypassing funds altogether) fund fees. However, if unguided, co-investing can disappoint. The reason is that passive co-investments are rather pro-cyclical (Fig. 1) and amplify the evolution of valuations witnessed at fund levels (Fig. 2). As a result, co-investments on average underperform funds.

Cambridge Associates and academics Lerner, Fang and Ivashina confirm these findings. LBO co-investments generated a gross performance of 1.32 times the amount invested while funds generated a net performance of 1.45x. The 371 venture co-investments analysed over 2002-2011 systematically underperformed funds. Anecdotal evidence from CalPERS over 1990-2014 shows that the USD 2.7bn it invested directly generated (an assumed gross) 12.8% IRR and 1.45x multiple on invested capital (MOIC), while its 60.7bn fund investments generated a net IRR of 11.4% and a net MOIC 1.46x (according to a program review quoted by PEHub).

Fine tune asset allocation

Second, co-investing can help fine tune an asset allocation. Assuming a significant and diversified flow of potential opportunities, co-investing supports a more flexible and precise allocation to private investments than with funds. However, the timing of investments is unpredictable: it relies on the investor’s origination capabilities or the fund manager’s deal flow (in the case of funds, co-investments are usually offered only when there is spare investment capacity). Investors face the risk of adverse selection when co-investing along funds, but also as a result of their own preferences. As a result, co-investing still remains essentially opportunistic: according to Cambridge Associates co-investments account for 5% of all private investments.

Learning by doing

Third, for some investors, co-investing is an accelerated journey up the learning curve towards autonomy in direct investing. However, this autonomy can only be relative. Co-investing requires an in-house team with the expertise to undertake due diligence (or an outsourcing budget) and ability to take decisions on relatively short notice. A more direct approach also requires sourcing capabilities to gain access to attractive opportunities. These significant costs imply a certain minimum amount of capital – and performance to recoup them.

Only investors with significant assets can develop in-house the expertise to invest directly at a global scale. Most cannot shun completely fund investing. They will invest alone only in markets and industries they understand, though at the risk of “home bias” investing and of portfolio concentration. Reaching a vast pool of qualified opportunities is thus important, notably as it helps preventing adverse selection. Selectivity is crucial. Accessing attractive opportunities can be difficult as they are often shared only among select investors.

Risk mitigation and diversification

Fourth, co-investing mitigates some risks associated with direct investing: investors benefit from the in-depth due diligence and skills of the lead investor. They can thus diversify more safely out of their core expertise. However the dynamics of a transaction will vary depending on the nature of the lead investor (strategic, industrial or financial).

These motivations determine the choice of the level of engagement of the investor when co-investing. As, investors want to be in charge of private investments, they will have to decide to which extent. Though investors generally want to keep their due diligence in-house, and capitalize on their own expertise, they often resort to additional external resources to challenge the lead investor and form their own opinion.

From delegation to tailored intermediation: the emergence of specialized advisors

The first step for investors is to apply the principle “know yourself first” and “assess what you bring to the table” (beyond capital). This results in a customized approach, thus determining the level of intermediation to specialized advisors. Depending on who invests and the goals, advisors can selectively be tasked to gather investment opportunities; operate diligence; aggregate assets and monitor investments (Fig. 3).

Intermediaries have accordingly adapted their operating model. On the sourcing side, of 80 American fund managers surveyed by PwC[2] in a 2015 survey, 64% offered co-investments and a further 19% were planning to. At the receiving end, wealth managers are assessing the best set up to help their clients to handle direct investment opportunities.

Thus, rather counterintuitively, private equity investing does not evolve towards disintermediation. Rather, intermediaries have evolved to cater to a wider range of investor needs and capabilities, offering the possibility for more tailored intermediation.

___________________________________________

Author biographies

Jose Camacho is co-founder of and leads origination at Touchstone Ventures, a direct investments advisory firm. An entrepreneur and investor, he counts on many years of corporate finance experience advising private companies on M&A and capital raising at UBS. Jose also leads the executive team of Business Angels South East Asia (Bansea) in Singapore. He obtained a Masters degree in Engineering (Communication Systems) from the Swiss Federal Institute of Technology complemented with a minor from HEC Lausanne.

Cyril Demaria is Executive Director, Private Markets Analyst at the Chief Investment Office of UBS in Zurich. He is the author of Introduction to private equity (2nd ed., Wiley, 2013) and of Private equity fund investing (Palgrave, 2015).

Dweep Chanana is co-founder of Touchstone Ventures, a direct investments advisory firm. Dweep worked for over 6 years at UBS Wealth Management, advising the bank’s top clients on impact and sustainable investing. He has previously managed an SME support program in Kenya, setup a language learning startup, and worked for several years in the telecommunications industry in India and the USA.

Figure 1 – Fund investments and co-investments (capital invested in mn USD) (1990-2014)

Source: Pitchbook, UBS CIO (2015).

Figure 2 – Average post-money valuation (USD mn), by investment channel (1990-2015)

Source: Pitchbook, UBS CIO (2015).

Figure 3 – Models of private markets investing

* Varying levels of asset owner involvement/discretion observed

Source: adapted from WEF/Oliver Wyman (2014), UBS CIO (2015).

[1] Global Family Office Report 2014, Campden.

[2] Private equity co-investments: Best practices emerging, in A closer look, PwC, January 2015. http://www.pwc.com/en_US/us/financial-services/regulatory-services/publi...