The macroeconomic landscape in recent years has presented certain challenges for both private equity General Partners (“GPs”) and Limited Partners (“LPs”). Deal activity and distributions were depressed in 2023 and early 2024, contributing to an overall slowdown in Private Equity (“PE”) fundraising and the length of time PE funds historically have taken to hold a final close. GPs, eager to strengthen relationships with LPs, are offering increased levels of co-investment opportunities to “sweeten the pot” and encourage fund commitments. This practice benefits GPs as they seek to finance new deals with increased levels of equity in the wake of a higher interest rate environment.
Over the last decade, co-investments have become ubiquitous within alternative investing. However, despite this recent rise in popularity, many LPs consider themselves under-allocated to the strategy. According to a recent Goldman Sachs study, within alternative investments, co-investments have the highest proportion of LPs looking to increase allocations over the next 2-3 years1.
Co-investments are frequently offered to existing LPs on a no management fee / no carried interest basis. This can result in a reduced fee burden which, combined with the strategy’s more efficient capital deployment, can help drive higher risk-adjusted returns. In return, GPs can use co-investing to right-size equity checks as well as to further cultivate relationships with LPs and cement their interest and willingness to invest in the next vintage.
Persuading LPs to commit to a fund has become an increasingly arduous task, particularly for GPs with smaller fund sizes. After years of growth, U.S. PE fundraising has stagnated, with total capital raised in 2023 of $370 billion. This fundraising amount, while similar in absolute dollar amounts to recent years, is across only 439 funds, a ~48 percent decline from 2022. PE fundraising in 2023 was concentrated up-market, particularly in funds over $1 billion in fund size2.
Additionally, private equity funds big and small have taken longer to reach a final close than in any time over the past 10 years. In 2023, the average time taken to close a U.S. PE fund was 15.6 months, the longest it has been since 2011. This trend continued in Q1 2024 with an average 16.9 months taken to hold a final close2.
For some LPs, co-investment opportunities can be a deciding factor in finalizing a commitment to a fund. Even as prospective investors, co-investing alongside potential managers can help LPs gain conviction in a PE firm’s strategy and processes. Witnessing the due diligence and underwriting rigor of a manager first-hand allows LPs to solidify their conviction in a manager and the investable opportunity set. GPs, aware of these dynamics, have begun to offer increased co-invest opportunities as the tough fundraising environment persists.
Another macro influence that is encouraging GPs to offer more co-investments is elevated interest rates. When the cost of debt is high, companies can support less leverage, incentivizing the use of a higher proportion of equity to finance deals. In 2023, U.S. BSL-funded LBOs were financed with ~54 percent equity on average, up from the 10-year average prior to 2023 of ~45 percent. Instead of increasing the equity check from a fund to fill this gap, impacting diversification guidelines, GPs can offer the excess equity as co-investments to LPs.
The combination of a shaky fundraising environment and an increased cost of debt has resulted in an increased level of co-investment opportunities for many LPs. For instance, at CF Private Equity, we saw an increase in private equity co-investment opportunities reviewed by ~38 percent from 2022 to 20233. Annualizing YTD May 2024 statistics, we estimate another YoY uplift in evaluated co-investment opportunities of ~47 percent3.
When LPs have a wider funnel of potential co-investments, they can be more selective—investing in only the most attractive deals alongside their highest-conviction managers. LPs can also benefit from this wider funnel in an increased ability and flexibility to negotiate better terms and fee agreements, potentially further increasing the attractiveness of co-investments as a more efficient strategy.
CONCLUSION
Although co-investing is an attractive area to invest at the best of times, co-investors can also benefit from periods of market dislocation like we’re seeing today through an increased number of opportunities to choose from. We expect co-investment deal flow to further accelerate this year as overall PE activity begins to recover while interest rates and the cost of debt remains elevated.
This heightened deal flow is particularly relevant for LPs focused on the lower-middle / middle-market, as GPs with smaller fund sizes have especially struggled with meeting targets and with elongated fundraising timelines. In conclusion, we believe LPs with adequate experience in co-investing and a wide network of GP relationships will be best positioned to capitalize on the current environment, reaping the benefits of increased selectivity and more attractive terms in driving outperformance.
- 2023 Goldman Sachs Asset Management Alts Survey
- Pitchbook: Q1 2024 US PE Breakdown
- CF Private Equity Internal Database
