A co-investment blueprint: If you take the leap, do it right

Co-investments are playing an increasingly important role for institutional investors seeking to reduce overall fees and allocate more capital to high-conviction managers. In fact, co-investing itself, which involves making direct investments into companies alongside lead GPs, and the process for choosing deals, are both quickly becoming key performance differentiators, making it important for managers to have well-thought-out strategies that address ongoing access to opportunities.

As we work with institutional investors to set a course for 2024 and assess their private markets strategies, we often start by advising them to consider the most efficient way to achieve long-term access to quality co-investment opportunities. For example, do they want to keep relying on lead GPs to do the heavy lifting, or do they want to be more engaged and take on more of the investing process itself, including sourcing and monitoring?

For those that choose to co-invest, efficiency of process is probably the single most important factor for success. One of the more common complaints from GPs is that many of their LPs demand access to co-investment opportunities but lack the resources and structure to execute successfully. If you decide to bring co-investing in-house, you need to candidly assess whether you have the resources and authority to do it right, and you need to have a strategy in place to review opportunities as they come in. There can be no stopping and starting or taking a long time to reach a decision point. With that in mind, here are five core ingredients for any successful co-investment program.

1. A well-defined investment strategy

Formalizing your co-investment program by defining its investment scope and target size will give you a valuable road map prior to considering any opportunities. Will there be an emphasis, for example, on a specific region or sector? Will you focus on buyouts, growth or venture? The scope can be broad – that is, US mid-market companies – or more targeted, such as European healthcare companies. The sizing of co-investments is generally dictated by each investor’s policies, portfolio construction and pacing models. In terms of the investment selection process, it should be flexible enough to try to go for the fences every now and then, but the goal is to seek to hit lots of doubles with your co-investments.

2. Streamlined decision-making

Co-investment deals happen in “transaction time” – within weeks or even days – while investments in funds can take months. This puts a premium on speed, agile decision-making and giving GPs either a firm ‘yes’ or a quick ‘no’ on an opportunity. To maximize efficiency and decision-making flexibility, and minimize the time required to make investment decisions, investors often follow the same approval procedures that are in place for fund investments. If you have a process in place that could cause delays – for example, having decisions be subject to approval from a board that only meets periodically – changes need to be made.

3. A manager selection process that is aligned with investment goals

It is critical to develop a repeatable manager vetting process that can help with due diligence. One path of least resistance is focusing on opportunities from managers with whom you have existing relationships, and thus have already performed comprehensive diligence and know their strengths and weaknesses. In other instances, investors may wish to consider co-investment opportunities from new high-quality managers on a case-by-case basis. Alignment in terms of expertise is key as well. If your program will focus on smaller and emerging managers, put the time in to find managers with experience and good track records navigating their markets.

4. Active sourcing and monitoring capabilities

While the benefits can be significant, co-investment transactions are inherently complex, require significant resources and structuring expertise, and involve multiple stages, from deal sourcing to post-investment monitoring. In terms of sourcing, LPs need to clearly communicate to managers the specific characteristics and objectives of their programs, and again need to be ready to execute when opportunities surface. Co-investments entail more monitoring complexity than a funds-only portfolio, and investors generally modify their existing processes to account for these nuances.

5. In-house legal and structuring expertise

One drawback of co-investing and its complexities is that it can expose you to a variety of legal and regulatory issues depending on the market, sector, structure, or type of deal. Co-investors need to be aware of evolving laws and regulations and must always adhere to the final terms and conditions set forth in the investment agreement. For these and other reasons, firms need to ensure they have adequate legal expertise and staff in place before they start to expand co-investment activities.

Co-investing can deliver substantial benefits to LPs, allowing them to allocate more capital to preferred managers at lower expenses, and to shape and customize their portfolios by targeting certain niche areas. The knowledge-sharing opportunities are invaluable, and those LPs that are successful at building long-term, strategic relationships with top managers will be in the best position to succeed.

But the risks are also numerous and must be well understood. Knowing exactly why you want to co-invest, formalizing your strategy and making sure that all the key ingredients are built into your program will go a long way toward making you a reliable, sought-after co-investor.

Steven Hartt and Ethan Samson are managing principals at Meketa Investment Group.