While co-investing has been a staple of the private equity industry for many years, it is a more recent and growing trend in the hedge fund industry. We believe that hedge fund co-investments are an important tool to increase the total return of portfolios, while limiting correlation to traditional asset classes and hedge fund strategies.
Prior to the global financial crisis the hedge fund industry experienced strong inflows. Many hedge funds enjoyed relative freedom to pursue niche opportunities and put less liquid investments into side pockets. In recent years, industry inflows have been more limited and investors have been more restrictive on permissible investments, particularly less liquid situations. As a result, hedge funds, outside of mainstream liquid strategies such as equity long/short and global macro, have had less discretionary capital available to deploy. This has coincided with regulatory changes that have decreased bank and insurance company willingness to invest in non-traditional asset classes, creating more opportunity for alternative forms of capital to fill that void. The end result has been an increase in established hedge funds seeking co-investment capital for discrete opportunities that do not meet the liquidity, concentration or asset class guidelines of their main funds.
From the investor’s perspective, fees, transparency and correlation are key focal points when it comes to hedge fund allocations. In our view, co-investments have the potential to provide improvement on all three fronts. Furthermore, they can provide a way for investors to target specific exposures and risk/return profiles that meet their investment objectives.
In short, we believe co-investments offer a clear and self-sustaining value proposition to hedge fund managers and investors. For managers, co-investments represent a new form of capital that enables them to participate in high-conviction opportunities that, absent co-investment capital, they would not be able to pursue. For investors, co-investments offer a means of direct access to differentiated sources of return with potentially bespoke risk/return profiles as well as attractive fees, transparency and control rights.
The primary difference is the universe of managers from which co-investments are sourced. Co-investing is a mature concept for private equity firms. Indeed, many private equity managers have established and often contractual processes for how co-investments are allocated among existing clients. Co-investing is a newer concept for hedge funds. Most hedge fund managers do not have a long list of existing investors with whom they have traditionally partnered on such investment opportunities. At the same time, most hedge fund allocators are not equipped to make decisions about co-investments. As a result, these opportunities tend not to be as heavily trafficked as private equity co-investments and there tends to be greater potential for tailoring implementation strategies.
Another important difference is the breadth of investment strategies accessible through each of the two categories. Private equity co-investments typically involve control private equity positions that are subject to the same factors that influence valuation of public equities. Hedge fund co-investments represent a diverse array of asset classes, liquidity profiles and risk. They can be “risk-on” or “risk-off” and everything in between. They can range from publicly traded equity and debt to non-traded investments, such as litigation finance and reinsurance, which have no correlation to traditional assets classes. For this reason, we would generally expect that hedge fund co-investments would have lower correlation to global equities than private equity co-investments. Hedge fund co-investments also tend to have shorter holding periods than private equity co-investments.
Today, sourcing is entirely dependent upon having access to a robust network of idea-generators. The most obvious sourcing channel comes from hedge fund managers with whom an investor has existing primary fund investments. However, it is increasingly common for hedge fund managers to solicit co-investment capital directly from allocators with whom no primary fund relationship exists. This is happening because few hedge fund managers have existing investors with active co-investment programs and managers recognize co-investments as an opportunity to broaden their client base and support future business growth.
While we believe there are many potential benefits to making co-investments, there are challenges as well. Broadly speaking, we see four key barriers to entry:
Generally speaking, alignment is achieved in two ways. It can come from assurance that a manager has “skin in the game”, investing personal capital alongside that of external investors. And it can come through fee structures that are akin to “sweat equity”. There are a wide range of fee structures (including no fees), but structures are typically skewed toward realization-based incentives over a performance hurdle whereby a manager is only compensated if the investment achieves the investor’s objectives.
We believe the primary role of hedge fund co-investments in client portfolios is to potentially increase expected return. Secondary benefits may include improving transparency, reducing average fees and introducing targeted exposures that are not correlated to existing allocations.
The trade-offs are that co-investments are resource-intensive and require quick response times. In addition, they can have higher risk and wider distributions of outcomes than traditional fund investments. Finally, co-investments may require more onerous contractual liquidity.
In our view, hedge fund co-investments have a distinct role to play in well-balanced portfolios, offering important diversification benefits to traditional asset classes as well as hedge funds and opportunistic investments. We believe that hedge fund co-investing will reach the level of adoption currently found in private equity, leaving significant runway for growth in the years ahead.
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