Seizing opportunities with private equity co investments

Private equity co-investments have generated even better returns than other private market strategies. (Image: iStock)

After 2021 was an excellent year for private equity, the market environment has now become much more difficult due to current developments. Middle market co-investments in particular, however, offer excellent opportunities for investors to take advantage of right now, says Marina Stoop of Zurich Invest.

Private equity had quickly overcome the Corona shock and posted excellent returns over the past several years. Even listed equities lagged private equity results, notes Marina Stoop of Zurich Invest's investment management team. According to Hamilton Lane, a franc invested in private equity as of the end of 2017 would have turned into a franc by the end of 3. Quarter 2021 CHF 2.36 become. By contrast, an investment in listed equities over the same period would have only made it to a value of CHF 1.53 brought. Even over a longer time horizon of 15 years, private equity beats listed equities by more than 3% per year.

Good returns drove above-average growth

As Stoop goes on to explain, private equity has enjoyed exceptionally strong growth over the past two decades. While the asset class in 1999 was still less than 0.5 quadrillion USD under management, it is now about more than 6 quadrillion USD of private equity capital. This corresponds to a growth rate (CAGR, Compound Annual Growth Rate) of more than 12. By comparison, the market capitalization growth rate of listed stocks is less than 7%.

Co-investments have outperformed other private equity investment styles

A closer look at the various investment options, she says, reveals that private equity co-investments have generated even better returns than other private market strategies (see chart). Dedicated co-investment funds outperform even growth equity and buyout funds. In particular, the lower fees of co-investment funds lead to higher net returns. Another feature of co-investment funds is that they often turn out more concentrated. Since there are significantly fewer co-investment funds than buyout funds overall, the dispersion of returns (dispersion) would be expected to be higher than for buyout funds. Over the past few years, however, there has been little difference in returns compared with buyouts, as the following chart shows. Overall, the risk-return profile is comparable to buyout funds", explains the investment manager further.

Yield and yield diversification

Co-investments offer a number of advantages

In addition to the appealing risk-return profile, co-investments offer investors a number of advantages over a fund-of-funds solution, he said. For example, the fees of a dedicated co-investment vehicle are significantly lower than the fees of a fund of funds. This is because there are no primary funds for which additional fees are charged. Co-investments are often made on a "no fee/no carry" basis-Basis offered (neither management fees nor performance fees are charged). "Co-investment vehicles also offer investors the opportunity to build their portfolio in a shorter period of time. Capital calls are faster and the desired exposure is achieved more quickly. These effects lead to a shortening of the J-curve. As with a fund of funds, investors enjoy "manager diversification", says Stoop.

The market environment has become more challenging

2021 had been an excellent year for private equity. The benign market conditions would have provided excellent returns. However, the market environment has become much more challenging in recent months. The ongoing Russia-Ukraine conflict, inflation, as well as rising interest rates and fears of recession characterize the current environment. This is accompanied by a pronounced correction in the stock market and increased volatility. The question for investors is therefore where to find attractive investment opportunities in the current situation.

The middle market segment offers numerous investment opportunities ..

The private markets represent an enormous investment universe. According to S&P Capital IQ, there are about 100,000 private companies in North America and Europe alone, of which about 88% belong to the middle market (defined here as companies with an income of 10-250 million euros). USD). In the opinion of the expert, the focus on the middle market allows to draw from the full potential. However, there are some pitfalls to be avoided.

… which specialists can also tap in the current market environment

The middle market is difficult to navigate, not least because of its inefficiency. However, this is exactly where the potential lies, which smart investors can exploit.

According to Marina Stoop, four categories of inefficiencies can be distinguished that can be exploited:

  1. Lower dependence on economic growth: The value creation process in the middle market segment is generally less dependent on economic growth. It is not uncommon for companies in this segment to have deficiencies in management and operations. However, since middle market companies are often less advanced in their life cycle, they still have a lot of potential for growth and optimization. These potentials can be identified by a qualified management team and exploited by operational adjustments. Experienced private equity partners can draw on their broad network of contacts.
  2. Procurement of investment objects and due diligence: Finding suitable companies in the middle market is not always easy, as information is often difficult to obtain. Therefore, private equity specialists are needed who know what information to look for and how to interpret it.
  3. Better divestment options: Larger companies are only attractive to a limited group of buyers precisely because of their size. In addition, these companies are often sold via an Initial Public Offering (IPO). This implies a greater exposure to the equity market. Companies in the middle market segment, on the other hand, often meet with broad interest from strategic buyers and financial investors.
  4. Selection leads to higher added value: Middle market buyouts have historically posted better returns than large buyout funds (see chart). Within the particularly well performing funds this difference is especially pronounced (+3.1% net IRR difference for the first quarter US Middle Market Buyout Funds vs. US Large Buyout Funds for 2000-2013 Vintage Funds). So selecting appropriate companies can pay off, especially in this market segment.

Selection makes the difference

Private equity co-investments as an attractive form of investment

Due to its special characteristics, the middle market represents a good basis for attractive investment opportunities, in the opinion of the investment manager. Co-investments with a low fee burden gave investors access to this type of investment. However, since these are particularly complex investments, with numerous factors to consider, it is advisable to work with an experienced specialist. This ensures that all opportunities are optimally exploited, he says.

"Private equity co-investments continue to present themselves as an attractive form of investment. While the market environment has undeniably become more challenging in recent months, the middle market in particular still offers favorable opportunities that can be exploited with the right know-how", emphasizes Marina Stoop.