By Lydia Tomkiw

Investors are increasingly looking to hedge funds for co-investment opportunities as a way to tap into managers’ best ideas and get better pricing and investment transparency terms. Long a staple of the private equity world, institutional investor interest in co-investing is stemming particularly from lower fees, longer investment holds, and the potential for high returns from getting access to high-conviction manager bets, industry watchers say. The vehicles are popular with activist investors and credit and distressed managers. Sophisticated investors, including large institutions, are participating most heavily in the space, with less interest from the family office and high-net worth space, market observers say. The demand for co-investments, through one-off vehicles or dedicated funds, has continued to ratchet up, according to an alts investing survey of 460 allocators from Deutsche Bank this year. Approximately one-third of allocators said they already co-invest with hedge fund managers, and of those, 59% are looking to up their allocations to co-investment opportunities during the year. Allocators that have not been active are also turning their attention to the space, with 15% of respondents saying they plan to make first-time allocations to co-investments this year. Co-investing has been a part of the private equity landscape for decades, and more recently has become a core market transaction for firms such as KKR, as reported. Hedge funds have been more recent entrants into the space, especially following the financial crisis of 2008, when many investors soured on side pocket arrangements in which managers cordoned off troubled assets and prevented clients from redeeming their capital. Co-investment vehicles have served as part of the answer for investors that favor taking larger or illiquid positions, says Russel Perkins, a partner at Dechert focused on the private funds industry. “To really get any kind of net returns beyond what the market is doing you have to take some risk, and these large positions in co-investment funds allow you to potentially gain some returns if the high-conviction ideas are correct,” he says. Amid pressure from investors for fee reductions across the hedge fund space, part of the upside for a co-investment vehicle is the potential for a lower fee arrangement. Managers can say to investors, “’We are still charging 1.75% [management] and 20% [performance fees] in our main fund, but you will also be given the opportunity to co-invest on a no-fee or reduced fee basis,” Perkins says.
Given that market backdrop, there has been “significant growth” in investor demand for co-investments, with allocators in a strong negotiating position as managers want to get deals done, says David Frank, CEO and managing partner of hedge fund marketer Stonehaven.   “This trend is motivated [by] several factors among allocators: transparency, fees, control, and no cash drag relative to funds ramping up during investment periods,” he said in an email, noting that the trend has especially flourished among smaller managers marketing individual deals instead of a fund. “Even after raising a larger fund, many managers are still willing to offer co-investment rights to attract and retain attractive allocator relationships.”
But larger managers are also offering the deals. Pershing Square Capital Management, Trian Fund Management, and Jana Partners are among the big names that have offered such vehicles, as reported. Co-investments in the hedge fund market typically come together quickly, with investors signing confidentiality agreements to hear about the opportunities managers are presenting, says Jason Kaplan, a partner at Schulte Roth & Zabel. Investors don’t encounter the opaqueness and portfolio weighting issues they could in other vehicles, with the timing, purchase of sales, and parameters of entry and exit usually set forth clearly, he says. Those conditions give investors that may not already be invested with a hedge fund manager a chance to see them in action. “[Managers] use this as an opportunity, as a carrot to attract investors,” he says. “It’s not only for existing, but also for prospective investors to create new relationships that don’t exist.” For managers, co-investments allow them to increase their capital in a specific investment that could have too much exposure in the main fund or to raise funds for an idea separate from their flagships. But the practice can also require a significant amount of work, especially depending on the terms set with investors, says Lance Zinman, global co-chair of at Katten Muchin Rosenman’s financial services practice. “Co-investment takes a little bit more devotion of resources from a manager,” he says. With shrinking amounts of capital in other parts of the hedge fund space, co-investment vehicles also offer an avenue for managers to tap new capital, and there has been a noticeable uptick in offerings from fund of funds platforms in this vein, says Stuart Blair, director of research at Canterbury Consulting. Investors evaluating such opportunities should be asking themselves, “What value add does that bring and are you not better off investing in that space with an actual private capital fund?” he says. While some wrong bets have led to significant capital losses through co-investment vehicles, the potential rewards are likely to keep fueling high interest, Perkins says. “I think there is going to continue to be interest in taking a position,” he says. “It might not be right for all investors, but for a significant portion of institutional investors it will continue to be attractive.” “It’s pretty much like everything – when an industry is not very much loved, it’s often the time to get into it,” Meneret says. “It doesn’t always work, but hedge funds have been there for a long time and I don’t think they are disappearing.”