equity market. In contrast, the co-investment market in private debt is significantly smaller. While co-investments have been around in private debt since well before the GFC, they are just now gaining traction. Of the USD 350 billion in annual corporate direct lending, we estimate that co-investments represent only 5%.
StepStone expect this proportion to grow over time. One can already observe an increase in both the number and the amount available for co-investors during the COVID-19 outbreak. To better diversify their portfolios and limit their exposure to individual companies, underwriting GPs have given to making smaller investments. To maintain their underwriting capabilities and compete for interesting opportunities, they are turning more toward like-minded partners to secure the necessary capital.
Co-investments provide financial benefits for the GP and LP alike. From the GP’s perspective, the most obvious advantage of co-investments is the ability to access capital needed to complete a transaction. Maintaining control over an investment, something notably absent in most club deals, and staying within the investment parameters set forth by the fund are other important considerations.
Also, co-investments offer several financial advantages to LPs:
First, they are typically done on a no-fee, no-carry basis, thereby improving returns.
Second, co-investments accelerate capital deployment and hence improve the dollar return for the investor.
Third, co-investments provide more flexibility for evergreen structures to reinvest capital returned by borrowers, thus mitigating the opportunity cost of fund investments.
Lastly, co-investments give investors greater control over their portfolio.
In particular, LPs can achieve benefits from diversification since they can access deals with managers of varying sizes, in different regions, with different sector specializations. As a result, co-investments are more efficient in terms of cost, capital deployment, returns and diversification.
Exhibit 7: Benefits of Co-Investments
Source: Preqin, StepStone Private Debt Internal Database
Like co-investments, secondaries provide many financial benefits. In a secondary transaction, an investor will buy a portfolio of seasoned loans, thereby reducing the overall deployment duration and ensuring a faster turnaround on distributions and higher returns. In addition, it is usually possible to buy secondary portfolios at a discount to the net asset value (NAV), which creates immediate value for LPs. Discounts can come about for a number of reasons including from sellers who require immediate liquidity.
Currently, the secondary volume in private debt is quite small, but as the asset class matures, we expect secondary volumes to grow and follow a path not unlike the one laid out by private equity. The COVID-19 crisis may act as a short-term catalyst for secondary transactions. Were prices in public markets to drop for an extended period, some LPs may be forced to sell part of their private market exposure to remain in line with their asset allocation guidelines. For levered portfolios, a deterioration in fundamentals may trigger margin calls by lenders and hence the need to sell assets to raise cash.
Investors ramping up their private debt exposure or with less stringent constraints will benefit from this selling pressure. A growing set of opportunities will also allow potential buyers to be more selective and better diversify their secondary portfolio. In addition to the financial benefits, co-investments and secondaries enable the LP to more thoroughly vet the GP’s investment insight, and to gain a better understanding of a GP’s capabilities and style. For the GP, co-investments and secondaries provide an opportunity to showcase its skill set and, if all goes well, persuade the LP to commit to a future fund.
Given the many benefits of co-investments and secondaries, why do most LPs not participate? For co-investments, speed is the biggest obstacle. Most private debt deals are finalized within two to three weeks. Unless the LP has a dedicated co-investment team, it is not equipped to make investment decisions that quickly. Though many LPs may mention the desire for co-investments when discussing a commitment to one of the GP’s funds, they are rarely able to execute when the opportunity arises. For secondaries, LPs need to have the ability to analyse many loans in a short period of time, which may also require a dedicated team.
While the intangible benefits of co-investments to both LPs and GPs are clear, debate over the actual results continues. Academic research, including a study by Fang/Ivashina/Lerner (2015),[8] raises significant questions about the performance of co-investments, specifically a concern about adverse selection. In a white paper[9] published in 2014, StepStone demonstrated that co-investment deals generally performed in line with their parent funds on a gross basis, outperformed them on a net basis, and, on average, had lower risk profiles than their parent funds.
This analysis suggests that GPs actually had higher conviction in the co-investment deals and they were not simply “selling down risk”. Therefore, the performance comparison shows that the adverse selection concern in co-investing may be overstated. Thus, compelling returns are achievable in co-investing as long as the co-investment program incorporates processes and structures to mitigate the risks associated with co-investing.
LPs source co-investments and secondaries through their primary private debt manager relationships. The key to creating a diversified co-investment portfolio is to see many co-investment opportunities. This is important for three reasons:
Selectivity matters: GPs typically review 1,000 transactions per year, but close on only between 3% and 5%.[10] A strong co-investment “flow” helps LPs to be equally selective.
LPs gain knowledge of the current deal environment and are able to better distinguish between “good” and “bad” deals.
With good “flow” LPs will be able to create more diversified portfolios.
As a result, the key to creating a strong co-investment portfolio is to have significant scale and be a meaningful partner to many GPs. This can be challenging given that private debt has fewer managers than private equity. To make the most of this situation, investors might rely on an adviser with the reach and scale necessary to cover the global private debt market.
Although each secondary and co-investment opportunity has its own idiosyncrasies, which engender a certain level of customization, there are several analyses that should be part of any investment due diligence. In light of how time sensitive these transactions can be, drilling down into these five criteria may be helpful to LPs as they decide whether to proceed:
covenants (see also section 6),
control/lender of record (see also section 6),
EBITDA adjustments (see also section 2.2.4),
leverage levels & Loan-to-Value (LTV) ratios,
gross asset yield.
High equity cushions and low LTV ratios are tantamount to “skin in the game” for private debt managers. These metrics provide powerful insight into whether the lead sponsors will be properly aligned with their
