Co-investment has become an increasingly popular way for limited partners (LPs) to invest alongside general partners (GPs) in private equity deals. By co-investing, LPs can gain more control and upside in select deals, while reducing fees paid to GPs. This article will explore the different forms of co-investment, motivations for LPs and GPs, and how co-investments can create value. There are several ways LPs can co-invest with GPs, including direct co-investments, sidecar vehicles, and fund reups. LPs benefit from co-investments through lower fees, reduced J-curve drag, and greater visibility into deals. However, co-investing also poses risks around adverse selection and conflicts of interest. When executed properly, co-investments can strengthen LP-GP alignment and provide differentiated returns, making it an attractive option as invest gain popularity.
Direct co-investments give LPs more control with lower costs
The most straightforward approach is for an LP to directly co-invest alongside a GP in a specific deal. Here, the LP conducts full due diligence and negotiates its own terms, rather than investing blindly through the GP’s fund. Direct co-investments involve little or no management fees and carry. They allow LPs to cherry pick deals they find attractive. By investing directly, LPs also gain more control over entry/exit timing and deal terms. However, direct co-investing requires significant resources and capabilities from LPs. They must replicate much of the sourcing, diligence, and post-investment monitoring done by GPs.
Sidecar funds offer advantages along with potential conflicts
Another common structure is a sidecar or co-investment fund set up by a GP. The GP sources all deals and handles due diligence, while LPs simply commit capital to the sidecar to invest alongside the main fund. Sidecars involve reduced (1-2%) management fees but often still have carry. LPs benefit from having a ready pool of co-investment opportunities without extensive legwork. However, sidecars can create misalignment if the GP earns carry on the sidecar before hitting hurdles on the main fund. There is also risk of adverse selection if GPs put their best deals into the main fund.
Co-investments create alignment and diversification for GPs
For GPs, co-investments help align interests with LPs and increase assets under management. By offering co-investment opportunities, GPs can incentivize LPs to re-up in future funds. Co-investments also allow GPs to pursue larger deals without violating fund constraints on individual investment size. Additionally, co-investments provide portfolio diversification benefits. The key risk for GPs is adverse selection – they have incentive to keep the best deals for their main fund and offer inferior opportunities for co-investment.
Proper structuring and oversight are critical for success
To maximize the benefits of co-investing, LPs must ensure proper oversight, governance, and alignment with GPs. LPs should have pre-approved eligibility criteria for co-investments based on size, sector, geography, and risk. Deal approval processes should be streamlined while still providing for thorough diligence. LPs must also implement comprehensive monitoring of co-investments alongside their fund commitments. With the right structures in place, co-investments can provide tangible benefits to both LPs and GPs when executed as part of a thoughtful overall invest strategy.
Co-investments alongside favored GPs provide a way for LPs to enhance returns and alignment while reducing costs. But appropriate diligence, governance, and oversight processes must be implemented to address risks like adverse selection. When executed strategically, co-investments are an increasingly popular mechanism for LPs to complement traditional private equity fund investments.