Co-investing in private equity refers to limited partners (LPs) investing directly in portfolio companies alongside the fund’s general partner (GP). Co-investing has become an increasingly popular way for LPs to gain more control and enhance returns. By bypassing the fund structure, LPs can reduce fees and access favorable deals. However, co-investing also comes with challenges like adverse selection, lack of capabilities, and short decision windows. This article will explore the motivations, risks, and best practices for LPs co-investing in private equity.
LPs Seek Higher Returns and Lower Fees Through Co-investing
The main appeal of co-investing for LPs is the potential for higher net returns, owing to reduced management fees and carry. According to surveys, 80% of LPs have realized returns exceeding those of regular fund investments. Co-investing also provides more control over deal selection and timing. Rather than investing in a “blind pool,” LPs can cherry pick attractive opportunities in specific industries, geographies or stages. Additionally, co-investing strengthens LP-GP alignment and relationships. It provides LPs better transparency into the GP’s operations and investment process.
Due Diligence and Decision Making Present Key Challenges
However, co-investing also poses several risks. LPs must contend with adverse selection, as GPs have incentive to keep the best deals for themselves. Co-investing requires specialized expertise and resources to properly evaluate deals within compressed timeframes. Many LPs lack the operational capabilities required. There is also the risk of overpaying for deals sourced by the GP. Appropriate governance, information rights and alignment mechanisms are necessary to mitigate risks. Smaller LPs may lack bargaining power in negotiations.
Best Practices Depend on LP Size, Relationships and Objectives
For LPs, prudent co-investment practices involve setting clear objectives, parameters and processes. A dedicated team with PE experience is invaluable. LPs should start slowly and focus on optimizing long-term GP relationships rather than short-term gains. Maintaining reputation and trust is critical. Larger LPs may benefit from separ
ate accounts or strategic partnerships instead of one-off co-investments. Overall, co-investing can enhance private equity programs but requires careful execution based on the LP’s specific needs and capabilities.
Co-investing enables LPs to boost returns and obtain deal access, but presents risks including adverse selection, lack of capabilities, and compressed due diligence. Successful implementation depends on strategic partnerships, governance, alignment mechanisms and dedicated resources.