The TEXPERS Blog

BY JIM MCKEE, Callan

Looking for improvement from your hedge fund allocation? Co-investing with hedge funds is a chance for investors to enhance returns while reducing overall fees.

Although co-investments have been a popular supplement to a fund sponsor’s private equity and real estate programs for decades, co-investing with hedge fund managers became a widespread practice only after the global financial crisis of 2007-2008.

The appeal of co-investing with hedge funds today arises from attractive opportunities that lie between the vast pools of liquid capital markets dominated by algorithms and indexers on one side, and the mountain of dry powder controlled by private equity providers on the other.

What are co-investments?

Co-investments are one-off investments that a hedge fund manager has identified which are typically too illiquid or oversized to absorb within the manager’s flagship fund. Another key feature of such opportunities is that they need to be assessed quickly for a decision to buy or pass—often within days or weeks. 

Fast-moving markets or events are frequently forcing the trade; being able to respond within a few days or weeks is the key for successful participants. Because market values of such opportunities are often not observable due to their size or illiquidity, the allure for co-investors is an asset trading at a notable discount to fair value, in addition to lower fees charged by the sourcing manager versus its commingled fund vehicle.

What have co-investments looked like in the past? 

Depending on the manager’s domain expertise, they could be Lehman claims, Icelandic bank debt, Puerto Rican bonds, Argentinian debt, Egyptian T-bills, CLO equity tranches, late-stage private equity, or an activist-controlled stake in a targeted public stock. Other investment opportunities may not be co-investments, per se, but are similarly attractive to experienced buyers looking for direct investments offered by motivated sellers at a material discount, such as hedge fund secondaries.

Motives behind offerings

Motives behind managers offering co-investments are many. In addition to a position being too big or too illiquid for their primary commingled fund, co-investments represent an opportunity to create and improve relationships with strategic clients while developing a supplemental revenue base. Since co-investments are usually offered under carefully described circumstances, investors in such opportunities should not construe them as the manager’s “best ideas”—one should expect those to continue going first into the manager’s flagship fund.

Investor expectations

Since co-investments are offered at lower fees, the investor’s expectation should be to improve performance at least by reducing the fees being charged. A collateral benefit is that co-investing efforts provide improved access to deal flow via dedicated sourcing experts. Furthermore, co-investing provides more transparency into a manager’s investment process. Because the manager’s compensation is typically driven by incentive fees, the investor can also be more confident in aligned interests to create desired investment outcomes. Nevertheless, working with multiple co-investing partners helps to improve diversification of trade risks.

Because resources and experience widely vary among investors, co-investment solutions have three primary forms to consider:

1. If limited partners lack resources to quickly vet and approve opportunities presented to them, they can consider a turnkey solution provided by a fully discretionary adviser, whether a hedge fund or fund-of-funds manager. The adviser of this turnkey solution sources the co-investment deals, underwrites them, and uses its full discretion to implement a commingled fund solution. It is the most fee-laden solution, but it is cheaper than the manager’s full-fee commingled fund.
2. Limited partners with demonstrated experience and ability to move quickly on any presented opportunity can oversee a managed account of approved co-investments that conforms to customized investment guidelines set up with the manager.
3. If an investor has significant size, experienced staff, and demonstrated resources, it can be a strategic partner working with manager sourcing, vetting, and investing directly in deals.

Like any private transaction lacking clear pricing or exit strategies, the motives of all participants are particularly important to understand. Investors need to know their limitations and act accordingly. When opening the door of co-investment opportunities, carefully understand your odds of investment success before the door shuts behind you.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Callan nor TEXPERS, and are subject to revision over time.

About the Author: 
Jim McKee is a senior vice president in Callan's Hedge Fund Research group. He is a shareholder of the firm. McKee earned a master's degree in finance from Golden Gate University in 1987. He received his bachelor's degree in economics/environmental studies from Dartmouth College in 1982.