An increasing number of LPs are spending more time negotiating co-investment opportunity rights. But the consequences of not executing on co-investment deals could be more serious than LPs imagine. Ask almost any general partner and they’ll anecdotally talk about the weeks spent negotiating with potential investors about how much co-investment opportunity they’ll get access to. Yet for many limited partners, those rights to co-investment deals go partially, or fully, unused throughout the life of a fund. Dan Witte, LaSalle Many LPs face staffing and resource constraints in being able to execute deals. Yet LP infrastructure isn’t the problem. The real issue relates to the consequences facing investors not fully executing on those hard-won rights for access to co-investment opportunities. One particular challenge of not executing on co-investment opportunities is concentration risk. For the majority of investors, the appeal of co-investment is the ability to add “a layer of tactical thinking to your strategy portfolio decisions,” says Ed Casal, chief investment officer of Aviva Investors’ global real estate multi-manager group. While co-investment opportunities naturally have some concentration risk, Casal says LPs want to ensure they are achieving some diversification in their deal selection. Russ Bates, head of Americas for Aviva Investors real estate multi-manager group, says that his firm would want to be in 15 to 20 deals per vintage of various joint venture opportunities. Aviva targets fund co-investment and joint venture deals and has executed 11 joint ventures and one fund co-investment deal in the last two years. He says that “you are taking some concentration risk with co-investment.” “That’s the trade-off,” says Casal. “But this is part of our tactical investing, based on where we see the opportunities and where we see the outlook for the economy.” Dan Witte, managing director in charge of LaSalle Investment Management’s strategic investments group, which runs the $600M Ranger co-investment program on behalf of the Teachers Retirement System of Texas (TRS), also warns about manager concentration risk. “We want to spread our bets among various managers,” Witte says. “Different managers go through different life cycles and have different organizational issues at different times. We therefore want diversification as it relates to manager concentration.” One of the greatest challenges of not executing on co-investment opportunities is the impact on LP-GP relationships. Witte says the primary reason TRS launched a co-investment program, which in 2015 is expected to invest $150M in deals less than $50M, was to be considered a strategic investor by its most important GPs. “They want to be at the top of the list of major investors that GP can go to when they find the best co-investment opportunities,” Witte says. Ed Casal, Aviva Casal explains the challenges facing one GP, who wanted to limit co-investment rights only to investors committing more than $100M of equity to their fund. “Ideally, they would prefer to work with a single co-investment partner who is prepared to execute quickly. However, there has been little certainty those co-investors can step up. So co-investments have typically been syndicated more broadly, often including to investors outside the existing fund.” Sometimes the inability to execute relates to LP infrastructure. Typically, investors are given between five and 10 business days to give a preliminary yes or no to a deal proposal, which can be accompanied by a lengthy analysis, says Bates. Witte says one deal for TRS took two and a half weeks to get to contract. Sometimes the failure to execute relates to timing. One Aviva co-investment deal was a result of a GP’s investors having all recently committed to a different co-investment opportunity. “In this case, the seller had tax needs to close by December 31, and the opportunity, including redevelopment cap-ex, was too large for the fund to complete,” Bates says. “None of the existing investors were able to commit additional capital, as they had invested in the prior co-investment. So six months after the closing, we were able to participate in approximately one-quarter of the equity position when the market had significantly improved. It was a timing issue as to why existing investors couldn’t co-invest.” Investors who repeatedly fail to execute on co-investment rights run the risk of turning into the boy who cried wolf. “The good GPs are trying to be very mindful of who they offer co-investments to,” Witte says. “You have to believe [as a GP] that your investors are ready and able to respond. If investors [repeatedly] don’t act, GPs might not be so responsive to that LP’s needs.” Casal adds that investors who fail to execute on negotiated co-investment rights also fail to add dynamism to their portfolio construction tools. “By investing tactically in co-investments and joint ventures, you bring the discretion closer to yourself, and you can tie the changes in your strategic thinking over time to your portfolio construction,” he says. “It’s more dynamic and more responsive. And in a fast-changing world, this approach should be more interesting to investors.”
An increasing number of LPs are spending more time negotiating co-investment opportunity rights. But the consequences of not executing on co-investment deals could be more serious than LPs imagine.
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