Dealflow dynamics are responding to increasing demand for Co-investments in Asia says Jie Gong, Partner in Pantheon’s Asia Investment Team
The popularity of co-investing has been on the rise in Asia. For LPs, besides the obvious benefits of lower cost of accessing PE investments and J-curve reduction, co-investments serve as a valuable feedback loop on the rigor and quality of the GP by offering LPs a front row seat at a live deal process. For GPs, co-investing has been an important channel to enhance LP relationships while solving the portfolio concentration issue for the larger investments.
Compared with the U.S, the flow of co-investments in Asia tends to be more sporadic. While the source of co-investments has traditionally been private equity funds which syndicate a portion of the larger deals to their existing LPs, with the increasing demand for co-investments, some new sources have emerged. There is an increase in the practice of stapling a co-investment with primary fund commitment by emerging managers in the process of raising their first or second funds to prospective LPs. In addition, deal-by-deal fund-less sponsors have arisen which typically offer co-investments to family offices and high net worth individuals, charging deal economics for their role in putting together the deal and driving value creation of the investment.
While these developments present new sources of co-investments, a crucial element may be missing in some of these cases: the confidence in the sponsor fit in a given deal through deep knowledge of the sponsor’s strength and expertise over years of building a primary relationship. In addition, the alignment between the GP and the co-investors needs to be strong, and may not be in the cases of some deal-by-deal fund-less GPs who have very little skin in the game. Sponsor fit and alignment play a critical role in the performance outcome and should therefore be an integral part of the overall assessment of co-investments from both existing and new GP relationships.
As a function of the private equity market development in the region, while the control deal volume has seen a gradual increase over time, the Asia co-investment flow is more often from minority stake investments and pre-IPO investments compared with the U.S, which is more control buyout centric. Portfolio concentration in such types of deals could lead to an over-reliance on capital market for realization, because the control on exit resides with the majority shareholder who in many cases may not be open to a trade sale. This puts more onus on portfolio construction to contain such exposure and reduce the dependence on IPO exits. Likewise, deal selectivity is imperative especially when it comes to the strength of a GP’s value creation thesis and the downside protection.
With more LPs in Asia requesting co-investments, an increasing number of GPs have proactively built in a layer of targeted co-investment capacity when calculating the targeted fund size against the deployment pace. However, not all the LPs that express interest for co-investment have built the commensurate in-house deal execution capability, which is critical given GPs’ general desire for speed and reliability in co-investors’ response in live deals. Those with a dedicated program and team with a transactional background are better positioned to act on opportunities. In addition, being attuned to GPs’ deal pipeline through a close relationship and keeping abreast of deal news in the market enable early engagement on opportunities. LPs that provide strategic introductions to co-invested companies through their extensive portfolio network domestically and internationally are likely to further differentiate themselves as a value-add partner. One successful co-investment collaboration generally leads to the next: it is a virtuous circle in building trust and establishing a comfort level in a co-investment relationship.