There has been much discussion about the move away from reliance on the equity risk premium towards other drivers of risk and return.
For many plan sponsors, that has manifested in large allocations to alternative asset classes such as private equity, real estate, infrastructure, agriculture, timber, and hedge funds. The belief is that these asset classes can offer better risk-adjusted returns and can access proven manager skill or the illiquidity premium and attractive income yields.
While there is widespread acceptance of the attraction of alternative asset classes, access to them can be expensive and governance intensive, leading investors to wonder if there is an easier, less expensive way to get the same results. That has led investors to explore many different implementation options in order to determine which ones best fit their needs and governance capabilities.
Historically, funds of funds and direct funds, except for the largest pension funds, have been the most common implementation approaches. Smaller investors and those under governance constraints will often use funds of funds as they provide a diversified portfolio, albeit for higher fees. Under this approach, the investor delegates portfolio construction and manager selection to a third party. Investors with reasonable governance and scale will often build their own portfolio of direct funds. It is a less expensive way to access an asset class but requires greater time, skill, and oversight along with sufficient access to quality managers to build a diversified portfolio.
More sophisticated investors have often negotiated co-investment rights when investing in direct funds. That has enabled them to increase their exposure to a particular deal through investing additional dollars directly in a company or asset. In fact, some investors are partnering with preferred managers to build a portfolio exclusively of co-investment opportunities. One of the key reasons for the increased interest is there are no management fees and often little or no carried interest on the co-investment. Co-investment opportunities can also accelerate the investment pacing and allow an investor to take a view on particular market themes.
So given these advantages, why aren’t more investors co-investing? In order to be successful, an investor has to be able to do the following:
• Find deal flow. Not all deals are created equal nor are all managers. The challenge for investors is to find the right partners who have steady deal flow and are willing to share the best deals with their partners.
• Assess which opportunities to pursue. Assuming the investor can secure regular deal flow, it has to be able to determine which ones fit within the portfolio that it should pursue. There is a chance the investment may not work out and a concentrated portfolio increases the risk of not achieving one’s goals.
• Have sufficient skill and capacity to complete the due diligence in a timely manner. Often, when an investor has an opportunity to co-invest in a particular company or asset, it has limited time to review the deal. The investor has to have staff or external experts who can review the due diligence in a timely fashion in order to determine the quality of the deal. As well, an investor should undertake due diligence even in situations where the direct fund manager is taking a portion of the deal for the fund. The investor also has to have appropriate delegation to act. It is rare that the investor can wait until the next committee meeting as most deals are time sensitive.
• Pay for due diligence and deal costs regardless of whether the investment is goes ahead or not. There will be some situations where the investor has decided to pursue a co-investment opportunity and through the due diligence process determines that the deal does not meet its investment criteria. There will be costs incurred in the due diligence process that will require a capital outlay regardless of the outcome.
• Be able to raise the required capital in a timely manner. As with delegation, an investor has to be able to raise the money to pay for the deal when it closes. That means understanding where the money will be come from and being able to deliver the cash as and when needed.
Given the issues, it is not surprising that many investors cannot meet these hurdles. For those that can, there is the opportunity to enhance overall portfolio returns.