Sovereign wealth funds are taking the lead in co-investment activity as the slowdown in private equity fundraising and hurdles to dealmaking prompt both limited partners and fund managers to team up on more co-investment opportunities.

The value of private equity co-investments involving sovereign wealth funds (SWFs), pension managers, corporate investors and family offices increased nearly 39% year over year in the first quarter to $42.3 billion, according to an S&P Global Market Intelligence analysis of recent co-investment activity by those four main private equity limited partner (LP) groups.

Co-investments involving private equity or venture capital firms partnering with SWFs are increasing, accounting for more than 47% of co-investment deal value among those four LP groups since 2021, up from 31% in the 2018–2020 period.

Typically offering lower fees and a more controlled risk-return profile than primary fund investments, co-investment deals may be especially appealing to LPs at a time when slower economic growth threatens to blunt private equity returns. For fund managers, known as general partners (GPs), co-investments can unlock capital for deals when fundraising is slow and financing is tight.

SWFs out front

During 2022, the median value of a co-investment with an SWF increased 23% year over year to $185 million. Pension funds went the other direction, with the median value of their co-investments plummeting 81% to just $52 million.

Compared with pension fund managers, many of whom are trying to resolve temporary over-allocations to private markets, SWFs may be in a better position to seize current co-investment opportunities, said David Fowler, co-head of the private equity product group at financial services firm The Apex Group LLC.

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Not only have they boosted allocations to private markets in recent years, sovereigns tend to have large deal teams, and that makes them particularly suitable for co-investments, which often require more LP involvement in investment due diligence and risk management, Fowler said.

Although the total number of SWF co-investment deals fell by 33% year over year in 2022, the 102 deals completed were well above the five-year average of about 90 per year since 2018.

Corporate investors partnered with private equity and venture capital firms on the most deals since 2018, far ahead of the other three LP groups, but those deals tended to be smaller.

Advantages amplified

Challenging macroeconomic conditions may be amplifying the advantages co-investments present to both GPs and LPs.

"Part of that story is you have a debt market that has evaporated … and if you have a deal that needs to get done you need to do it with equity, more or less," said Josh Beers, partner and head of private equity investments for investment advisory firm NEPC LLC.

Co-investments can allow a private equity fund manager to get around self-imposed limits on how much a fund can allocate to a single asset, and the LP partner's capital could offset a decrease in the credit facility available for investment, he added.

For LPs, co-investments are attractive in part because they often involve lower fees, which can boost investment returns. The potential upside may be even greater now, with the ability to enter new investments at a trough in the economic cycle, Beers said.

JP Morgan Asset Management, in a private equity outlook report issued in February, predicted co-investment opportunities for limited partners would grow in 2023 as private equity fund managers seek capital in a slow-moving fundraising environment. The co-investment opportunities offered to LPs are often part of a larger deal that also includes a commitment to the GP's primary fund, the report said.

Beers said that dynamic is especially important for new and emerging fund managers. Those GPs are battling a broader "flight-to-quality" movement that has LPs focusing on relationships with a smaller number of top-performing managers, he said.

"Newer fund managers that are out there raising capital, they tend to use co-investment as a way to attract dollars," Beers said.