As limited partners continue to seek co-investment opportunities, the rise in deal valuations poses unique challenges. Mergers & Acquisitions interviewed limited and general partners at yesterday’s Rising Stars of Private Equity SPEAK for their take on how to secure the coveted investment slots. Key takeaways: LPs are increasingly focused on earnings growth relative to multiple expansion, and are cautious about ballooning leverage levels.

“Our expectation at the moment is that any co-investment opportunity we see is likely to be at an elevated valuation,” says Aware Super growth equity investment analyst Karen Nes. “But we need to be able to invest through market cycles, and that’s been validated over the past several years, as many transactions we thought were at high valuations then, a few years back, have performed very well today.” 

Amid numerous reports that LPs are clamoring for inclusion in new fundraisings, roughly a third of LPs told Coller Capital’s Global Private Equity Barometer last month that getting insufficient allocation to desired co-investments was a factor in changing their co-investment policies. Remember what investor Sheryl Schwartz told Mergers & Acquisitions at The Best in M&A Speak virtual event in May:  “It’s a very competitive market. It’s hard to get into funds, it’s hard to get good allocations. And even more importantly, it’s hard to get co-investment opportunities, which a lot of LPs want.”

Enter a rich deal multiple environment and co-investment options can get even more complicated. “In the current environment we’re probably a bit more focused on understanding the GP’s value creation plan,” Nes says. “We really want to see the key drivers of return being [earnings before interest, depreciation, and amortization] and revenue growth rather than multiple expansion, and in most cases we’re testing the sensitivity to multiple contraction on exit as well just to see the impact on returns.”

This scrutiny extends to the amount of leverage private equity is using in transactions as well. “In terms of valuation, we really want to understand valuation relative to underlying growth of business, and we’re probably being in this environment a little bit more cautious in regard to the leverage levels that we’re seeing,” says Nes. “We’ve seen leverage levels creep up significantly above 5x on a number of deals, and we’re a bit more cautious and uncomfortable accepting risks at this level.”

While opportunistic deal sourcing can mitigate the need to pay a full multiple, and thus chase leverage-heavy deal structures, transaction multiples and values are surging to all-time highs. “Having an LP co-invest is a great check on your deal enthusiasm,” Encore Consumer Capital co-founder Robert Brown said on yesterday’s panel. His $260 million fund deploys equity checks in the $10 million to $30 million range, with regular opportunities for larger sums. “You have to sell that multiple to the LPs so we appreciate having our LPs around the table helping us think about things as part of the diligence process to make sure they’re not seeing things we’re not seeing.”