By Erik Sherman

There’s an old rule in communication: showing is better than telling. One such telling detail is how deeply California Public Employees’ Retirement System (CalPERS( has moved into a part of private equity called co-investing.

Co-investment is an investment made by a limited partner alongside a general partner of a private investment fund. Rather than investing through the fund itself, the LP is invited by the GP to invest directly in a particular company or opportunity.

In June 2024, Anton Orlich, managing investment director of private equity at the pension giant gave an overview of PE, including co-investment, to the CalPERS Investment Committee. The pension’s PE portfolio had a net asset value of US$72.6 billion. CalPERS has been transferring more equity risk to private from public although public equity remains the largest part of the institution’s portfolio.

“The role of the private equity program is to enhance equity returns through [an] active, value-added approach,” Orlich said. In other words, moving money from public equities to private equities can result in higher returns and better support for future pension obligations.

Of those overall NAV figures, co-investment was just shy of 10% at almost $7.2 billion. However, things have been changing within its renewed and focused commitments in PE.

In the fiscal years 2022-2023 and 2023-2024, CalPERS PE “achieved a long-standing goal of 40% in co-investments,” Orlich said. in year-to-date commitments, representing a significant strategic shift. “This long-standing goal is critical to being able to implement private equity in a cost-efficient manner and in a manner that increases our net returns. For some time, approximately two decades, CalPERS Private Equity pursued a cost-reduction strategy that was at the expense of net returns. Over the last couple of fiscal years, we’re concentrating on manager selection to produce the best net returns and using co-investment to reduce the costs and provide structural alpha for the portfolio.”

The combination of factors is fascinating. The manager, or GP, whether viewed as a firm or an individual in the firm has to be a party that through insight and skill can beat market results. It’s a necessary qualification. If the GP is hit-or-miss compared to some benchmark — say either a market weight or equal weight S&P 500 index — the pension fund might as well choose a low-cost index fund. However, given the financial responsibilities and goals of the pension, an index fund would be a highly suboptimal choice.

CalPERS does the research and finds appropriate managers. It then invests in those funds to build the relationship. Once established, a reverse qualification process happens and the GP invites CalPERS to take part in co-investments.

The reason co-investment is so desired is because the process is typically less costly in fees than the broader funds. As true with any investment, the less expensive it is to participate, the greater the actual returns. It’s why for so many individual investors, classic index funds can provide stronger returns than many other funds. They are cheaper to operate because the focus is to mirror the index and participate in roughly equivalent returns. Costs are lower to investors, so the returns are ultimately higher, allowing greater compounding.

But why is co-investing typically less expensive than a PE fund? Because the co-investor does more of the work.

Meketa Investment Group principals Steven Hartt and Ethan Samson asked in a Private Equity International article in March 2024 whether LPs “want to keep relying on lead GPs to do the heavy lifting, or do they want to be more engaged and take on more of the investing process itself, including sourcing and monitoring?”

According to the authors, GPs commonly complain that many LPs “demand access to co-investment opportunities but lack the resources and structure to execute successfully.” Without the resources necessary to undertake more of the investment process, an institutional investor should avoid the temptation.

That said, the Meketa authors also wrote that “co-investing — as well as the process for choosing deals — is quickly becoming a key performance differentiator, making it important for managers to have well-thought-out strategies that address ongoing access to opportunities.”

Presuming Canadian pension funds have the resources — obviously many do — here are the “five core ingredients” that Meketa thinks is necessary for success in co-investing.

First, they need to have a “well-defined investment strategy.” Make the co-investment program formal with strict definitions on investment targets and scopes.

Second, streamline decision processes. Unlike fund investment that frequently takes months, co-investing is often opportunistic and needs completion within a few weeks, or even days.

Third, a vetting process for managers is critical. Performance is important, but so is finding one aligned with your investment goals. Working with existing relationships with managers might make sense, but so might looking at opportunities with a new one.

Fourth, co-investments are “complex, require significant resources and structuring expertise, and involve multiple stages from deal sourcing to post-investment monitoring.” Clear communication with the GP is important and monitoring is more complicated than with a funds-only portfolio.

And fifth, co-investment can involve legal and regulatory risks, depending on the specifics of the deal. Have the legal expertise and staff in place before starting a co-investment.