Keynote Interview: Unlocking outsized returns in the lower mid-market

How would you describe the volume and quality of co-investment opportunities you are currently seeing?

Vahit Alili: The current market environment is certainly more complex than the one we saw in the bullish years of 2021-22, but we are seeing strong and compelling dealflow nonetheless. There are two main reasons for this: first, when interest rates started to increase, dealflow slowed significantly. Initially the opportunities we did see were overpriced as valuations remained high. We consciously raised our bar as a result and moderated our investment pace. Since the second quarter of 2023, however, valuations have come down – in some sectors, quite substantially. In that repriced environment, we are seeing attractive opportunities and have accelerated our investment pace.

In co-investments, the quality of dealflow is also a function of transactional capabilities. We are benefiting from our historical investment in the area and our sector team set-up, which has made us a natural partner for GPs seeking a sophisticated co-investor who can efficiently co-underwrite investments.

How would you describe the current supply/ demand dynamics surrounding co-investment?

Jeremy Knox: A confluence of factors is driving the availability of co-investment, including the availability and cost of debt, which has changed materially from periods like 2021 and resulted in a higher percentage of equity going into transactions. Meanwhile, slower fundraising has left many GPs with less capital to put into deals, which has again left a hole that co-investment is able to fill.

Additionally, we have seen a meaningful change in the competitive intensity from other co-investors. A number have exited the market entirely due to the denominator effect. This has created a truly advantageous environment for those with committed capital to remain active. This has been reflected in our median cheque size increasing substantially over the past 12 to 18 months, and we expect these trends to remain in place over the medium term.

Lastly, GPs have come to appreciate speed and certainty in co-investment transactions, which enables firmer conversations with sellers and more efficient processes.

Which parts of the market do you believe offer the most interesting co-investment opportunities?

David Bajada: We see the most exciting, and what we believe to be the highest potential, opportunities in the lower mid-market – for example, businesses with an enterprise value in the range of $100 million-$500 million. Historically, this segment has been less reliant on financial engineering and multiple expansion, and has focused primarily on implementing value creation initiatives that create true company transformation.

We believe today’s more challenging market environment will separate the best from the rest based on the ability to generate alpha through true transformational change.

In order to implement those value creation strategies, you need the right skill sets, of course – which is why we typically work with specialist managers over generalists.

Our co-investment strategy is consistent with our firm-wide approach across investment types, whereby we place a big emphasis on our Western buyout strategy complemented by Asia growth strategy. In the West, we see opportunities to build bridges between a family- or entrepreneur-owned business, transforming them through professionalisation or operational enhancements before selling them into the more competitive market segment. Here, we tend to see large-cap private equity funds competing with strategic buyers, resulting in premium exit valuations.

In contrast, in Asia we see fast-growing businesses with the potential to become market disrupters, capitalising on trends such as import substitution – where foreign brands are replaced by local ones – and demographic tailwinds.

India, in particular, is becoming an increasingly attractive investment destination as companies reconfigure their supply chains away from China.

While demographics across Asia are changing, India still has a relatively young population, with rapid urbanisation and digitalisation the main catalysts supporting its further strong growth.

How do you see the co-investment opportunity evolving as the economic environment improves?

Vahit Alili: I think this will depend on which part of the market you are focused on. The lower mid-market opportunity set is so wide and the transformational potential of companies within it is so significant that we do believe our returns are somewhat detached from the broader economic cycle. This means there are compelling opportunities at any given point in time.

Of course, in this more challenging economic environment, it is possible to access many fundamentally strong businesses at lower valuations, that means when the general macro environment improves and interest rates potentially correct again, many investments made in today’s environment could have the potential to generate outsized returns.

Do you have preferences in terms of sector focus and how to perform due diligence on co-investment opportunities?

VA: We focus on non-cyclical sectors with strong, long-term tailwinds, which has led to around 50-60 percent of our investment going into healthcare and technology. We also invest in business services, consumer and industrials, but this is on a more selective basis, prioritising differentiated, tech-enabled business models, recurring revenues and/or buy-and-build opportunities in highly fragmented markets.

Our approach to due diligence, meanwhile, is differentiated across our platform. We have 6,000 portfolio companies in our fund of funds business, giving us powerful insight into different sectors, regions and trends. We also have more than 400 GP relationships globally to tap into for reference calls, as usually some of our partners will have hands-on experience in a space on which we are conducting due diligence. We also have access to Schroders’ public equities team, which has a deep understanding of the market as well as the large strategics that are often potential acquirers of our private company investments. Those insights inform our due diligence and selection process.

Additionally, an ongoing culture of learning is a key part of our investment philosophy. As a result, we have excluded certain types of investments such as capex-intensive business models.

What is the secret to successful co-investment?

JK: There are a number of factors that lead to successful co-investments: deep relationships with best-in-class GPs; having strong relationships led and covered by local investment professionals in local markets across global strategies; efficient and transparent investment processes with proven execution ability; sector expertise, which allows both parties to gain an understanding of opportunities quickly; and a large sourcing engine to enable high selectivity, rather than being compelled to proceed on a deal simply because it has come across your desk.

Ultimately, there are two crucial elements to co-investing: willingness and the ability to execute. We try and separate ourselves on execution. Successful co-investors need to be able to execute within the constraints of tight timelines and the natural evolutions of live deals. That ability to execute is paramount when it comes to getting the next call from a GP.

What advantages can co-investment bring to an LP portfolio?

DB: The main benefit of a co-investment strategy is that it gives you access to a broad opportunity set, allowing you to be highly tactical and flexible in terms of how you build out your portfolio. It creates added diversification compared with a typical primary fund structure by providing a wide range of deals across various business models, sectors, geographies and GPs.

The element of GP diversification allows co-investment fund managers to leverage a wider range of high-quality dealflow and select the best opportunities from their broad base of GP relationships. Furthermore, it provides investors with a more fee-efficient form of investing. Co-investment transactions are typically sourced on a no-fee, no-carry basis, which results in a single layer of fees being charged to the underlying investor of a co-investment fund. Co-investment funds, meanwhile, generally charge both a lower management fee and performance fee, reducing the overall fee drag and potentially enhancing net returns.