Altius Associates, the US-based advisory and investment manager, has underlined the risks associated with co-investments in a recent study.
Altius analysed 886 realised US buyout and growth investments ranging from 1979 to 2012 and found that in constructing a 10-company co-investment portfolio from that sample, “there is a substantial probability that the entire portfolio would generate an IRR below 0 percent”. It added that “even with a 20-company co-investment portfolio it is still possible to lose significant capital as measured by either IRR or multiples”.
In order to analyse the various possibilities, Altius said it “randomly selected portfolios of 5, 10, and 20 investments and calculated the returns of an equally weighted portfolio as the average IRR across the portfolio”. It then generated 10,000 iterations for each of these portfolios.
Based on a 10-company co-investment portfolio the study found that “growth funds do not generate an attractive return profile under any circumstances” with the average IRR measuring -8.1 percent.
A 10-company buyout fund co-investment portfolio, on the other hand, produced an average IRR of 14.2 percent. However Altius warned, “the dispersion of returns indicates that there is a probability that the returns could be poor, even across an entire portfolio”.
The firm said adverse selection and portfolio concentration were key risks to consider.
GPs, for example, may have “an incentive to keep the highest expected return investments wholly within the fund structure” to increase their personal share of carry. Meanwhile, LPs usually only invest in a subset of a manager’s portfolio and this may lead to an over-concentration, Altius said.
William Charlton, head of Americas investment at Altius, said : “Care should be exercised to avoid the issues of intentional or unintentional adverse selection. Even if adverse selection can be avoided, there should be an appreciation for the nature of the risk inherent in a portfolio that contains a small number of risky investments that are likely to be highly correlated.”