Rather than investing in a hedge fund manager’s main fund, co-investments enable an institution to invest alongside a hedge fund manager on a specific project that may be one of many investment ideas the fund may be utilizing. Although the report didn’t cite it, one popularized example on the outer edge of the investment may be Bill Ackman’s Pershing Square investing in Allergan, Inc. (NYSE:AGN) and partnering with Valeant Pharmaceuticals Intl Inc (NYSE:VRX) who is seeking to acquire the firm.
While co-investments have been commonly utilized in the private equity world, often constructed using a limited partnership structure, their growing popularity in the larger hedge fund world tend to utilize more non-standardized fund structures.
The J.P. Morgan report notes that anecdotal as well as empirical evidence documents the growing trend and specifically cited the firm’s Capital Introduction Group Institutional Investor Survey for 2014, in which 52% of respondents indicated they would be interested in a co-investment opportunity. Most accepting of the concept were endowments and foundations (74%); consultants (68%); pension funds (60%) and family offices (59%) willing to participate in such an opportunity.
Interestingly, the J.P. Morgan report notes that one catalyst may be coming from the 2008 financial crisis and the unwillingness of investors to tolerate illiquid “side pockets” that prevent investors from accessing their funds. Co-investment strategies, since they are focused on a single opportunity or theme, don’t generally utilize side pockets.
The report noted hedge fund managers popularizing such co-investment opportunities to market are shareholder activists and credit orientated managers. Activists, such as Ackman, “have introduced innovative co-investment structures to allow them greater flexibility as they position size as part of corporate governance campaigns.” Credit managers in less liquid, longer term plays might include capital structure arbitrage, bankruptcy reorganizations and long term relative value credit plays.
Incentives for hedge fund managers
There are a few incentives driving managers to move in the direction of co-investment, the report noted. Activist managers can gain additional influence in assigning board seats if they have a partner who is technically independent but shares the same views and goals. Thus, restraints on an activist fund manager’s control of a company can be mitigated to various extents through a co-investment situation.
Credit-orientated fund managers utilize co-investments to solve different problems. “In the restructuring context,” the report noted, “a hedge fund may seek to acquire a control position in a company through various levels of the capital structure prior to a Chapter 11 proceeding so that it can guide the incourt reorganization. Concentration limits and risk management guidelines may again prevent such funds from doing so. Even absent such constraints, a fund may lack sufficient capacity to amass the necessary position. Offering co-investment opportunities can negate those impediments.”
The desire for speed
Regardless of the investment strategy, investors must be able to react quickly. The report tells the tale of a hedge fund fund of funds who was asked by a fund manager to invest in a relative value bond play that required quick decisions to execute the opportunity. With the need for speed competition for deals is lessoned, which can benefit the investor. Because some institutional managers may not be able to act with such speed, “by allocating capital to a dedicated co-investment vehicle – either directly through a manager or through an intermediary such as a FoF – institutional investors can essentially purchase, or “outsource,” the ability to act with the requisite speed since such vehicles are structured to draw capital as needed when trades that are suitable for co-investments arise. (Whether institutional investors that allocate capital to co-investment opportunities do so directly or through intermediaries depends on investors’ underwriting and diligence capabilities.)”
Benefits to institutional investors
Speed is one benefit, but institutional investors may also benefit through reduced fee structures (in some agreements management fees may be eliminated, performance fees can average 10% to 15% of profit), alignment of interests with the fund manager and enhanced transparency. Unlike investing in a fund, where the details are hidden behind a legal fund wrapper, a direct co-investment also provides direct access to all the investment operations and financial details.
There are various structures that typically relate to the investment type. Activists, for instance, might structure an investment tied to a particular event or defined commitment period and include a variety of methods to achieve capital distribution. Such deals typically feature a lock-up for a stated term and may include capital calls if more capital is required.
The growing trend towards co-investment has many detailed nuances and is evolving as we speak.