Associate Ed Pearson evaluates hedge fund co-investment and
how it is becoming more prominent in the marketplace.
Hedge fund co-investment is a growing area, and the data
suggests this growth will continue if investors have their way. In a 2014 JP Morgan report it was suggested
that almost three-quarters of endowment and foundation investors,
and two-thirds of pension funds were willing to participate in
them. Deutsche Bank's 2015 hedge fund survey
found over 70% of respondents planned to increase their
The benefits of co-investment do not solely accrue to investors.
Used appropriately, managers can take positions they would not
otherwise be able to take due to internal risk limits,
concentration limits or lack of scale. These benefits have led
co-investment to become a well-established practice in private
equity, real estate and infrastructure funds.
But hedge funds are often constructing very different portfolios
from closed-ended funds, and this raises some specific risks and
considerations for hedge fund managers contemplating co-investment
Probably the biggest risk is reputational. A co-investment that
performs particularly well may prompt investors in the main fund to
ask the manager why it was made available for co-investment
participation. If the manager was so confident in the success at
the time, why did they not invest more of the fund in the position?
Fair allocation issues require the engagement of the fund's
board of directors, whose objectives and duties may be in tension
with those of the manager in these matters.
More obviously, a co-investment that performs poorly has the
potential to annoy (at best) the co-investment partner. As these
co-investors are often drawn from the manager's largest or most
long-standing investors, or have been offered the opportunity as an
inducement to invest in the flagship fund, the impact of
underperformance can be challenging to manage.
Execution risk plays a part too, specifically speed of
execution. While institutional investors will profess in surveys
some enthusiasm for co-investment, many cannot complete their
investment approval process within the accelerated timetable of
most hedge fund trades. For larger hedge funds, who may run into
genuine capacity constraints only very rarely, the management of
co-investment deals can be complex.
At their heart, these matters come down to investor relations.
Managers have to prepare themselves for honest conversations with
their flagship fund investors and their co-investors (as well as
their independent board) about matters of fair allocations or
portfolio performance. Fund documents need to describe all relevant
arrangements, and a fund with a flexible constitution and clear
documentation can navigate these issues more easily. As ever in
these relationships, communication is key.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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