The risks of co-investment for hedge fund managers

The risks of co-investment for hedge fund managers

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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 co-investment allocations.

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 arrangements.

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.

Walkers Global is a principal sponsor of GAIM Ops Cayman 2016.

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