February 25, 2014
Interviewed by: David Snow
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Co-Investing: Selection Skills are Paramount

The Chief Economist of investment giant AlpInvest Partners argues that strong deal flow and a well resourced selection discipline can lead to co-investment outperformance. Read AlpInvest’s co-invest white paper here. AlpInvest’s own portfolio of co-investments has vastly outperformed the co-investment opportunities it turned down.

The Chief Economist of investment giant AlpInvest Partners argues that strong deal flow and a well resourced selection discipline can lead to co-investment outperformance. Read AlpInvest’s co-invest white paper here. AlpInvest’s own portfolio of co-investments has vastly outperformed the co-investment opportunities it turned down.

Co-Investing: Selection Skills are Paramount

With Peter Cornelius of AlpInvest

David Snow, Privcap:

Today, we’re joined by Peter Cornelius, the chief economist of AlpInvest Partners. Peter, welcome to Privcap today. Thanks for being here.

Peter Cornelius, AlpInvest Partners:

David, thank you very much.

Snow: I have on my iPad, a white paper that you have done into co-investment. It’s both very interesting and important. I’d love to ask you all about it. Why don’t we start at a bit of a thousand foot level and talk about co-investing and how it is increasingly popular among LPs and yet there is some apprehension among LPs that they might suffer adverse selection if they go into a co-investment program despite their best intentions to add performance to the portfolio.   

Cornelius: What motivates limited partners to do co-investments? I believe, in particular, two things. One is a favored fee structure. Either you don’t pay any fees or the fees are significantly lower. Second, you mitigate the J curve which is an important consideration given the liquidity constraints many limited partners have.

In our research, however, we found that the deal selection is absolutely critical. As important as a J curve effect is and as important as the fee issue is, deal selection is particularly important.  That’s the outcome of our research.  

What do I mean by deal selection? I think there are two issues we need to separate here. One is the quality of the pool of invitations that a limited partner receives. Second, the selection skills a limited partner has. These are two separate issues. One is the quality of the pool of invitations from which a limited partner then chooses the best investment opportunities.   

Now, the smaller the number of co-investments that you are involved in, the higher the risk that you are concentrated in a portfolio of co-investments. That is what adverse selection is about. You need to have a critical amount of co-investment capital to avoid a concentrated portfolio where you may end up with underperforming deals regardless – and that’s very important – regardless of the preferable fee structure co-investments give you.

Snow: Let’s talk a bit more about this white paper and this research that you’ve put together. It is based on AlpInvest’s own history as a co-investor, both a prodigious co-investor and also over ten years of having done it. AlpInvest has been invited many, many times to participate in co-investments and has said yes to a sub-segment of those invitations. Talk a bit about that co-investment function and what you did with it to come to your research conclusions.

Cornelius: So over the last three years, o the pool of invitations we have seen were roughly $18 billion US dollars. We invested roughly 1.6 billion over three years. Compare this with a very broad pool of invitations we saw at a very early stage of 18 billion. I think that’s very common.  Five to ten percent of all the potential deals you might get involved in. Now, obviously that requires very significant resources to do due diligence on those deals and to screen the opportunities that are out there.  

Roughly five to ten percent of the entire universe of potential invitations and the pool of invitations can be very significant.  In our particular case, over the last three years, roughly $18 billion US.

Snow: Let’s learn about what you discovered about your own co-investment activities. How did AlpInvest do as a co-investor? The opportunities to which you have said yes, how did they perform against other groupings of investments?  

Cornelius: The short answer is for the realized deals, those deals where we are a co-investor have outperformed by a factor of two relative to those deals we declined. 

Then we wanted to know given the pool of invitations how good have we been in terms of our own selection skills? The answer is that the deals that we have selected have outperformed those we have declined by a factor of two, a very significant outperformance.  

Snow: Can you talk about the importance of the co-investments within the overall portfolio including the fund investments? How much of an impact has the outperformance of the co-investments that you’ve participated in been on the overall performance of private equity?

Cornelius: Well, co-investments represent roughly 20 percent of our overall portfolio. It makes a very significant contribution to the bottom line of our total performance. 

Snow: Given the amount of resources and people and brain power that is needed to sift through these many invitations that you get, how would you have done in theory if you had just said yes to everything?  

Cornelius: The answer depends very much on the extent to which you factor in risk. Almost by definition, if the invitations are an unbiased sub-sample of the overall portfolio, you are exposed to it through your primary fund business, the performance should be relatively similar if you accept all the invitations. You may get some leverage out of the superior fee structure in co-investments but not much.  

Really what we find in our research is that deal selection matters very critically. The answer would be perhaps a little bit outperformance but that’s not really what should be driving the business factoring in the significant costs of running a co-investment portfolio. We have a dedicated team of more than 20 people worldwide and obviously you would need to bring this into the equation.

Snow: If you said yes to everything, you were simply allocating to a slightly lower fee index of your existing fund portfolio and maybe that’s not worth the effort.

Cornelius: Absolutely. It brings us again back to the point of adverse selection. If you choose a very small number of co-investment opportunities, there is a risk that you pick riskier deals.

Snow: It sounds like one of the key recommendations then is that if you’re going to co-invest you should have one exposure to a meaningful deal flow and two, smart people who can help you sort through the opportunities. That’s not easy to do. What would be a recommendation for a mid to smaller-sized LP that wants to get into co-investing and yet doesn’t have the deal flow and can’t afford the large staff of smart people that AlpInvest can?

Cornelius: The most efficient answer to this, I would say, is to pool resources. Several limited partners could decide to pool their co-investment invitations. They make fund investments, they may generate co-investment deal flow and they can pool those invitations and have an experienced co-investment manager select those deals.

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