CalPERS and CalSTRS have each dramatically increased allocations to co-investments. Other LPs, too, are ramping up co-investment programs as a way to reduce costs without harming returns. But the two pension fund titans, and others, say it takes time to develop the expertise to launch co-investment programs.

Calpers sign

Demand for co-investment is soaring as institutional investors are rapidly adopting direct investment elements of the so-called Canadian Model in pursuit of lower fees.

CalPERS has earmarked roughly 50 percent of its $73 billion annual private equity allocation for co-investments, projecting a cost savings of $2.5 billion a year. Similarly, CalSTRS’ co-investment portfolio has expanded from about 2.5 percent to 20 percent today and estimates $245 million in savings in 2022.

Law firm Cleary Gottleib cites a survey showing 67 percent of LPs have the desire to emulate the two California pension titans and launch co-investment programs of their own.

But co-investments may be easier than they appear.

For starters, LPs must be able to move quickly when presented with a co-investment proposition. Many institutional investors, especially pension funds, aren’t known for the speed of their decision making.

The CalSTRS board, for instance, recently authorized the private equity staff to move as quickly as needed to close co-investment deals. That took years of work starting in 2020 when CalSTRS launched its “collaborative model” to reduce costs, control risks and increase expected returns through internal management.

CalSTRS is seeking to raise its co-investment commitment to 35 percent of its portfolio. To help get there, in 2020 it embarked on a five-year plan to hire 91 new investment professionals and formally split its investment house into a public arm and private arm.

LP advisor Kelly DePonte says LPs need to develop staff to sift through co-investment offers.

“LPs fear that they will get involved in a deal where the GP is stretching too much, either in a too outsized deal or in a sector they feel the GP doesn’t understand well,” he says.

That takes expertise.

“Many LPs feel they need to pick and choose co-investment opportunities and not take everything offered,” says DePonte, who operates Kelly DePonte Advisory. “That means they need a team (or external consultant) with different skills than their fund investment team to do their picking and choosing, usually with a different and added compensation matrix.”

That’s why the $21 billion California’s Orange County Employment Retirement System is moving to expand its private equity staff from two to five people. It plans to allocate $75 million a year, 10 percent of its PE budget, to co-investments.

“We need to get close to the deal,” OCERS CIO Molly Murphy told the board last year before it approved the staff expansion. “We need to stop paying layers upon layers of fees.”

OCERS in March made an $8 million co-investment in a Nordic enterprise software company in a transaction led by the London-based HG.

The $495 billion CalPERS is pushing hard to boost its co-investments far above the current nine percent of private equity NAV. It upped its PE commitment by four percent in large part to pay for the increase. Fully 40 percent of its $15.5 billion annual PE spend has been committed to co-investment in each of the last two years. It made $4.9 billion in 80 co-investments in the last half of last year, including a $650 million investment in Ares Senior Credit Investment Partnership III.

Anton Orlich, who manages CalPERS’ $73 billion PE portfolio, says co-investments done right reduce costs and increase returns. That includes selecting successful managers to invest alongside.

“For some time, approximately two decades, CalPERS pursued a cost reduction strategy that was at the expense of net returns,” Orlich told the investment committee on June 10.

CalPERS’ big move into co-investments will come at the expense of buyouts in general and buyout mega-funds in particular. CalPERS is seeking to reduce its exposure to high-leverage investments and is turning its attention to middle-market funds.

“Middle market specialists rely less on leverage,” Orlich says.

In the last year, CalPERS has sunk $600 million in co-investments as part of its $100 billion commitment to addressing climate change.

Orlich estimated that co-investments save $400 million in management fees and carry paid out over the lifetime of every $1 billion invested in profitable funds.

Orlich also says CalPERS is moving into co-investments because of their predictability. Unfunded commitments made to traditional PE funds can be unpredictable.

“We know exactly what our exposure is with more precision than we do when we’re predominantly investing with funds,” he said at a November CalPERS meeting. “We can’t control the rate at which our managers ask for capital. But that’s the advantage of the co-investment structures, we get to be consistent in that co-investment amount.”