LPs face a co-investment conundrum

Investors weigh up improved net returns against enhanced concentration risk as they determine their appetite for co-investment.

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Just over one-third of respondents to Infrastructure Investor’s LP Perspectives 2023 Study plan to co-invest alongside general partners over the next 12 months, aligning with the strong demand being recorded by GPs.

“Co-investment remains at the forefront of investors’ minds, and particularly in the minds of intermediaries,” says Sandra Lowe, partner at InfraRed Capital Partners. “Towards the end of last year, a lot of intermediaries were telling us that there was no new money available for primaries in Q4, but that there was money available for co-investment.”

One of the primary benefits of co-investment is their advantageous economic quality. With pressure on net returns, that appeal is only growing. “Co-investors get much better terms because they are investing more of their capital for free or at a very low cost,” says Bruce Chapman, co-founder of Threadmark. “For many, being active co-investors means they are effectively halving their fees.”

Gordon Bajnai, partner at Campbell Lutyens, says: “Co-investment has become a major trend over recent years with mid-sized to large LPs building in-house due diligence capabilities and increasingly demanding direct exposure to deals.

“Many consultants have also built dedicated co-investment capabilities, giving them greater control of their exposure to individual managers, sectors and geographies. It is also a good fee reduction strategy, of course.”

Chapman adds that some institutions have reached a point where the bulk of their infrastructure activity now involves co-investment. “That is a significant development because, just a few years ago, most investors would prefer or even require a fund commitment before co-investing in order to properly underwrite the manager. Now some feel experienced enough to lead with co-investment.”

Raising the bar

However, Monument Group partner Bart Molloy believes many institutions are raising the bar when it comes to co-investment. “The fundamental drivers of co-investment remain strong, but I think investors will be highly selective,” he says. “It won’t be a case of, ‘If it is good for the manager then it is good for me,’ in this kind of environment.”

Lowe agrees, pointing to the fact that co-investment increases concentration risk at a time when markets are uncertain. “It will be interesting to see whether there is a slowdown in appetite for co-investment as a result of that heightened concentration risk,” she says. Despite anecdotally strong appetite, the percentage of survey respondents planning to co-invest next year is significantly down on the 51 percent that reported co-investment appetite in 2022.

Currency fluctuations may also have a role to play, says Bajnai: “If you are an LP and you commit to a blind pool fund, that fund will be invested over the next three to five years. That means there is a strong chance that the current strength of the dollar against the euro, yen or any other currency will not hit you. However, if you co-invest right now and get drawn immediately, those currency issues can be highly problematic. The dollar has fallen back a bit, so the situation may ease, but that could potentially have an impact on co-investment appetite.”

Perennial obstacles to co-investment also remain, with the speed required to conclude transactions once again being cited as the biggest inhibitor. Other challenges highlighted include the necessary ticket size and a lack of internal resource. Meanwhile, the inherent additional risk is a deterrent for 30 percent of respondents.

The supply of co-investment is also likely to remain strong, given a more challenging fundraising environment. “There was a temporary pause in the second quarter when it felt like supply was slowing, but since then we have continued to see strong dealflow,” says Brent Burnett, head of real assets investments at Hamilton Lane. “It is taking GPs longer to raise their funds, which means they are being cautious about how much exposure to a particular asset they want in the main vehicle. That is creating additional co-investment opportunities.”

But while deals are still getting done, they are taking longer to complete, Burnett adds: “There is still good liquidity in the market, but financing packages are taking longer to line up. That is slowing co-investment activity to a degree.”

Meanwhile, Jessica Kennedy, managing director at Northleaf Capital Partners, expects to see more secondaries transactions in the co-investment space. “It is not something we have seen happen a lot in the past,” she says. “But given the overallocation issues some investors are facing, we do expect that activity to pick up.”