Perspectives
Issue 13 October 2014
Key Commentary - the truth about co-investments
The ‘adverse selection’ argument
There is some “received wisdom” that co-investing should be avoided
A private equity co-investment is a direct investment in a company
because of so-called “adverse selection”, the assertion that co-
made alongside and on the same terms as a lead general partner
investments, either because of their greater size (and hence being
(“GP” or “sponsor”). A co-investment opportunity generally arises
outside the scope and expertise of the lead sponsor) or for other
when the amount of capital required to make an investment is larger
reasons, will generally under-perform the average private equity
than usually provided by the lead sponsor alone. Sponsors generally
investment, including all of the opportunities that are not offered as co-
prefer to invite their LPs to co-invest rather than share the opportunity
investments. A deeper analysis of the adverse selection argument
with another, perhaps rival, sponsor in order to retain control and
raises the question as to whether, if adverse selection does indeed
maintain track record attribution. However, LPs need to respond
exist, why does it exist? It could be owing to either or both of two
quickly to an invitation to co-invest and demonstrate both the
reasons: (i) co-investments offered are inherently of lower quality;
expertise and experience necessary to evaluate the target company,
and/or (ii) the co-investor chooses poorer investments systematically.
assess the financial structure, analyze significant due diligence
material and review and agree relevant and often complex investment
As to whether co-investments offered are of inherently lower quality,
documentation.
there is little, if any, industry-wide data to support this somewhat
cynical view. However, this hypothesis can be tested by simply
Co-investments are an efficient way of maximizing returns from a
looking at a sponsor’s historical track record and comparing it to the
portfolio of private equity fund investments. As co-investments do not
performance of investments where co-investors were brought in and
generally incur fees and carried interest charged by a sponsor, they
where they were not. Anecdotally, GPs state that they would not
reduce overall costs and, other things being equal, improve the net
deliberately offer less attractive deals to an LP co-investor, if only to
returns to the LP. However, co-investments also offer other benefits to
preserve the relationship with the LP and ensure a commitment to the
portfolio construction such as shortening the J-curve, controlling the
next fund, which is a GP’s lifeblood. As one sponsor stated, “Why
investment pace and emphasizing particular geographies, industries
would we want to spend the first hour of a fund-raising meeting talking
or lead sponsors. Diversification by lead sponsor can be particularly
about the co-investment that went wrong?” There is some evidence
important.
that very large syndicated transactions are on an under-performing
trajectory and this has certainly been evident with some large-cap
Committing to a co-investment
buy-outs undertaken in the period before the financial crash in 2008.
The concept of co-investing does not translate into a part-time
This trend has been documented in a recent article by Professor Josh
endeavor; it requires the same dedication as direct investment. Like
Lerner1.
all investment activity, co-investment should be undertaken in a
rigorous way by an experienced team and not carried out on a part-
Co-investment at Capital Dynamics
time basis by individuals who have multiple responsibilities such as
Capital Dynamics’ approach to co-investment involves a dedicated
evaluating multiple LP commitments to private equity funds. Spending
and experienced team that sources opportunities from the firm’s
just part of their time on co-investment will likely lead to poor
network of approximately 800 GP relationships. The opportunities
investment decisions and may also disturb the relationship with the
selected for investment are typically held in a co-mingled fund which is
sponsor if it causes delays to the process, thus frustrating transaction
managed by the firm on behalf of its clients. This approach has the
execution.
benefit of pooling sponsor relationships, not only to increase the
number of opportunities but also to maximize the amount of co-
“Here lies an issue; all investments must be made on their merits
investment made available to Capital Dynamics’ co-investment
alone and not based on a sponsor relationship the LP is seeking
platform. A sponsor will often allocate co-investment based on the
to preserve”
size of an LP’s commitment to its fund as well as favoring LPs with
dedicated, experienced teams to minimize execution risks.
These potential pitfalls demonstrate the need for dedicated and
smaller
Capital Dynamics refines its approach to co-investment further by
investors seeking the cost advantages of co-investment should pool
focusing on mid-market companies with an enterprise value between
their resources with other investors and mandate a dedicated external
EUR 50 million (USD 65 million) and EUR 1 billion (USD 1.3 billion).
team to undertake co-investment activity. Although this has a cost, it
This approach has two advantages: (i) avoidance of large-cap or
should avoid poor decision-making and has the added advantage of
mega-cap transactions where the equity capital required may be a
experienced
investment
professionals,
suggesting
that
increasing the pool of sponsor relationships from which to source coinvestment opportunities, so improving selection.
1
‘Nurturing Innovation’, London Business School Coller Institute of Private Equity, Issue 9
Winter 2013/14, pages 6-8
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multiple of the GP’s normal investment size; and (ii) focus on
The results of this approach suggest that it can produce attractive
situations where the opportunity is close to the core expertise of the
returns with the added benefit of lower costs which may potentially
lead sponsor where the particular deal requires, say, 30% more
lead to higher net returns to investors.
capital than usually provided by the sponsor alone, thus avoiding socalled “style drift”.
Various investor surveys echo Capital Dynamics’ experience with coinvestments. For example, a recent survey of 132 global investors
The co-investment team also focuses on five broad industry groups:
conducted by Advent International, 20% of which have dedicated co-
energy/power,
consumer,
investment teams, indicated out-performance of co-investments 2. 55%
healthcare/financial services and industrials. This sector-based
of respondents reported co-investments have out-performed fund
approach has the advantage of ensuring that investments are made in
investments on a net basis and for about 30% of respondents, it was
areas of proven expertise. Regarding the approach to any particular
too early to judge performance.
technology/business
services,
mid-market opportunity within the industry groups mentioned above,
the team considers the following features of each transaction in
In conclusion, a well conceived co-investment strategy focused on the
investment selection:
mid-market coupled with careful, disciplined execution can be an
attractive addition to a private equity investment portfolio.




Analysis of the lead investor’s track
record in the sector
Complexity of the
transaction/consortium
Barriers to entry and pricing power
Favorable growth trends in the
respective sector
Key market observations – global buy-out
Fund-raising
300
400
350
250
300




Attractive entry valuation for a quality
business
Positive sector momentum/cyclical
upswing
Favorable macro environment
Experienced, driven management
team
Alignment of interest through
incentive structure
250
150
200
150
100
Funds

USD bn
200
100
50
0
US
50
2004
2005
Europe
2006
2007
Asia-Pacific
2008
2009
2010
2011
2012
2013
H113
H114
0
Number of funds
Source: Capital Dynamics; based on Thomson One, Asian Venture Capital Journal (AVCJ)
Halfway through 2014, global buy-out fund-raising continues to
improve at a steady pace. 120 buy-out funds raised USD 74 billion
during the first half, being 10% more than the figure for the same



Market dynamics
Emerging markets growth
Acquisitions
period last year. As the chart above illustrates, fund-raising
demonstrates stable investor interest in traditional buy-outs. There
are no signs of investor over-allocation to this asset class as we
saw during the prior buy-out boom in 2005-2008. Since 2009, buy-out

IPO, trade sale to a strategic or
financial buyer
funds have raised USD 530 billion or almost half of the amount raised
during the previous five years, thereby alleviating the connected
problems of so-called “dry powder” surplus, new deal pressure and
competition. During the first half of 2014, buy-out funds in Asia-Pacific
attracted significant investor capital with the region boasting four
billion-dollar plus closes, including USD 3.5 billion secured by TPG
A disciplined investment selection approach underpinned by proven,
Asia. The region is on track to have its fifth consecutive year of growth
documented and repeatable processes is key.
in fund-raising.
2
Advent International “LP Co-invest Survey Highlights” June 2014
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remain relatively robust. M&A exit volume increased 60% to USD 139
billion; including large trade sales such as the USD 13.5 billion exit
Investments
900
from Biomet and the USD 6.5 billion realization of Oriental Brewery.
3,500
800
3,000
700
USD bn
500
2,000
400
1,500
300
Deals
2,500
600
Performance (Net IRR since inception as of March 2014)
25
1,000
200
0
US
2004
2005
Europe
2006
2007
Asia-Pacific
2008
2009
2010
2011
2012
2013
H113
H114
0
Number of deals
Source: Capital Dynamics; based on AVCJ, Dealogic, Thomson One, Unquotedata
20
Net IRR in %
500
100
19.6
16.4
15
12.4
10.6
10
7.6
6.8
5
Buy-out investment activity increased at a moderate pace during the
first half of 2014. Buy-out funds invested USD 145 billion or 7% more
than the same period last year across 1,240 deals. Invested capital
increased across regions. A 10% increase in the number of deals
relative to a year ago is an encouraging sign of deal flow
improvement, which, in turn, has a positive effect on coinvestment deal flow. In particular, private equity firms have
dominated deal vendor activity for several quarters in Europe,
resulting in a surge of secondary buy-outs. In H1 2014, deals sourced
from private sellers accounted for nearly half of all deals announced,
reflecting improving confidence across the wider deal-making
community. Buy-out acquisition prices climbed further, driven by
public market valuations, the availability of attractive debt financing
and strategic M&A. However, acquisition prices vary across
0
Upper
Median
Lower
Mid-cap buyout funds (USD 0.3bn-2bn)
Large-cap buyout funds (USD 2bn+)
,Source: Capital Dynamics; based on Preqin buyout funds of vintage years 2001-2010
Buy-out performance continued to improve, driven by improving
trading of portfolio companies, elevated exit activity and a rise of
comparable market valuations. Large-cap buy-out funds benefited
most from the low interest rate and high equity pricing environment as
indicated by short-term returns. However, mid-cap buy-out funds
continue to out-perform large-cap buy-out funds. According to our
analysis of Preqin data, the top quartile return since inception of midcap buy-out funds formed during the last decade exceeded that of
large-cap funds by 3.2 percentage points in terms of net IRR.
sectors, deal sizes and regions, thus demanding more than ever
global co-investment deal sourcing and rigorous selection ability.
Exits
400
350
300
USD bn
250
200
150
100
50
0
M&A
2004
2005
Public
2006
2007
2008
2009
2010
2011
2012
2013
H113
H114
Dividend recapitalization
Source: Capital Dynamics; based on AVCJ, S&P Capital IQ, Thomson One, Unquotedata
Private equity is on track to achieve the best exit year since 2007. As
we commented in our 2013 issues of Perspectives and Private Equity
Insight, “Private equity is currently in the distribution cycle. Exits
gained speed in 2014 with multiple exit options available”. In the
first half of 2014, record-breaking IPO activity and robust dividend
recapitalization, driven by the availability of debt financing, was
complemented by the return of corporate buyers. As demonstrated in
the chart above, private equity-backed IPO proceeds increased 172%
to USD 63 billion, the highest semi-annual volume on record. Dividend
recapitalizations declined 6% to USD 32 billion from a year ago but
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Meet our specialists
Andrew Beaton is a Managing Director and Cohead of Co-investment at Capital Dynamics. He
has 29 years of private equity and investment
management experience. Prior to joining us,
Andrew co-founded a private equity firm focused
on mid-market consumer companies. He also
held a number of senior positions in Europe and
the US with GE Capital before becoming chief
executive of GE’s European private equity
activities.
David Smith is a Managing Director and Cohead of Co-investment at Capital Dynamics.
David and Andrew have worked together closely
since meeting at GE Capital in 1990. David is
also Chair of the firm’s Clean Energy and
Infrastructure Investment Committee and a
member of its global Investment Committee. He
serves on the Board of Directors of the Major
Projects Association and is a member of the
Institution of Engineering and Technology. David
has over 26 years of experience in private equity
and infrastructure financing.
Oliver Schumann is a Managing Director of the
co-investment team at Capital Dynamics. Oliver
has 20 years of experience in private equity and
investment management. Prior to joining us,
Oliver held positions with Arthur Andersen, GE
Capital, Sal. Oppenheim and Resurgence Asset
Management.
Luca Giacometti is a Director of the coinvestment team at Capital Dynamics. Luca has
26 years of experience in private equity and has
been at the heart of Italian private equity since its
inception. Prior to joining us, Luca held positions
with Citibank, Banca Commerciale Italiana (now
Banca Intesa), GE Capital and the Ferrero
organization. Luca has an extensive network of
contacts of Italian business professionals,
entrepreneurs and intermediaries.
Andrew Bernstein is a Director in Investment
Management at Capital Dynamics. He has over
15 years of experience in private equity and
principal investing. Prior to joining us, Andrew
worked in mezzanine as a vice president at
TCW/Crescent Mezzanine and as a director at
Canterbury Capital Partners. Earlier in his career,
he worked for multiple groups within the Fixed
Income, Currency, and Commodities Division at
Goldman, Sachs & Co. In addition, he has served
as a board member for multiple middle-market
companies. Andrew holds a Bachelor’s degree in
Management from Binghamton University and an
MBA from Columbia Business School.
Capital Dynamics is an independent, global asset manager, investing in private
equity and clean energy infrastructure. We are client-focused, tailoring solutions
to meet investor requirements. We manage investments through a broad range
of products and opportunities including separate account solutions, investment
funds and structured private equity products. Capital Dynamics currently has
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USD 19 billion in assets under management/advisement . Our investment
history dates back to 1988. Our senior investment professionals average over
4
20 years of investing experience across the private equity spectrum . We
believe our experience and culture of innovation give us superior insight and
help us deliver returns for our clients. We invest locally while operating globally
from our London, New York, Zug, Beijing*, Tokyo, Hong Kong, Silicon Valley,
Sao Paulo, Munich, Birmingham, Seoul, Brisbane, Shanghai* and Scottsdale
offices.
Disclaimer: This document is provided for informational and/or educational
purposes. The information herein is not to be considered investment advice and
is not intended to substitute for the exercise of professional judgment.
Recipients are responsible for determining whether any investment, security or
strategy is appropriate or suitable and acknowledge by receipt hereof that
neither Capital Dynamics AG nor its affiliates (collectively, “Capital Dynamics”)
has made any determination that any recommendation, investment, or strategy
is suitable or appropriate for the Recipient’s investment objectives and financial
situation. A reference to a particular investment or security by Capital Dynamics
is not a recommendation to buy, sell or hold such investment or security, nor is it
an offer to sell or a solicitation of an offer to buy such investment or security.
Capital Dynamics may have a financial interest in investments or securities
discussed herein or similar investments or securities sponsored by an asset
management firm discussed herein. The information herein has been or may
have been provided by a number of sources that Capital Dynamics considers to
be reliable, but Capital Dynamics has not separately verified such information.
Nothing contained herein shall constitute any representation or warranty and no
responsibility or liability is accepted by Capital Dynamics as to the accuracy or
completeness of any information supplied herein. Past performance is not
necessarily a reliable indicator of futures results. Before relying on this
information, Capital Dynamics advises the Recipient to perform independent
verification of the data and conduct his own analysis hereto with appropriate
advisers. Analyses contained herein are based on assumptions which if altered
can change the conclusions reached herein. Capital Dynamics reserves the
right to change its opinions or assumptions without notice. This document has
been prepared and issued by Capital Dynamics and/or one of its affiliates. In
the United Kingdom, this document has been issued by Capital Dynamics Ltd., 9
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Redistribution or reproduction of this document is
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Capital Dynamics comprises Capital Dynamics Holding AG and its affiliates; assets under
management/advisement, as of March 31, 2014, include assets under discretionary
management, advisement (non-discretionary), and administration across all Capital
Dynamics affiliates. Investments are primarily on behalf of funds managed by Capital
Dynamics
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Average years of experience held by Capital Dynamics’ 20 most-senior investment
professionals
* Capital Dynamics China is a legally separate company operating under a strategic
cooperation with Capital Dynamics.
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