Co-investing has become an increasingly popular approach for limited partners (LPs) in private equity and other alternative asset classes. By investing directly into deals alongside general partners (GPs), LPs can gain greater control over their portfolios, access deals with potentially higher returns, and build closer relationships with GPs. However, co-investing also comes with risks and challenges that LPs must consider. In this article, we will explore the advantages and disadvantages of LP co-investing, examining the motivations, strategies, risks and key considerations for successful implementation.
The main benefits of LP co-investing
There are several key benefits that motivate LPs to pursue co-investing strategies:
Higher returns – By investing directly into specific deals rather than through a fund structure, LPs can capture more of the upside from top-performing investments. Studies show co-investments regularly outperform fund investments by 5% or more.
Lower fees – Co-investments typically don’t carry the same management fees or carried interest as fund investments, resulting in significant cost savings.
Control – LPs gain more control over their portfolios by cherry-picking specific deals rather than committing capital to a blind pool. This allows customization to strategic objectives.
Access to deals – Co-investing provides access to deals an LP might not otherwise see, including outsized or proprietary deals beyond a fund’s concentration limits.
Relationships – Working closely with GPs on co-investments fosters closer alignment and strengthens relationships. This can be beneficial for future fund commitments.
Common risks and challenges with LP co-investing
While the benefits are clear, LPs also face risks and challenges with co-investing that must be managed:
Adverse selection – LPs are dependent on GPs providing quality deal flow and have little recourse if co-investment opportunities are inferior. GPs may cherry pick the best deals for their funds.
Blind pool risk – The inability to control deal flow timing means LPs face the risk of capital calls without viable investment opportunities. Maintaining ample liquidity is key.
Timing constraints – Co-investment decisions often need to be made very quickly, sometimes in as little as a few weeks, requiring streamlined diligence and approvals.
Lack of diversification – Direct investing tends to result in a less diversified portfolio concentrated in relatively few deals.
Monitoring costs – LPs take on more direct monitoring and governance costs compared to relying on the GP as an intermediary.
Limited resources – Direct investing requires specialized skills and bandwidth some LPs may lack, especially for complex or international deals.
Effective co-investment implementation and strategies for LPs
For LPs to invest successfully, they should:
– Ensure strong governance and develop standardized co-investment policies and procedures. This includes setting guidelines around asset classes, diversification, due diligence requirements, and decision-making authority.
– Build a dedicated co-investment team with specialized skills in sourcing deals, conducting due diligence, negotiating terms, and portfolio monitoring. Supplement internal resources with external expertise if needed.
– Develop a broad network of GP relationships and seek co-investment rights during fund commitment negotiations. Offering differentiated value-add can incentivize GPs.
– Look for creative deal flow channels beyond sole reliance on existing GP relationships, such as independent direct investing platforms.
– Maintain a large cash reserve or credit facility to preserve flexibility for co-investment capital calls.
– Focus co-investing selectively in sectors, geographies and deal types where the LP has a competitive edge rather than spreading too thin.
– Implement expedited diligence and investment decision processes to meet compressed co-investment timelines.
Methods for gaining co-investment exposure
LPs have a few options to gain co-investment exposure:
Direct co-investing: LPs invest directly into companies and assets alongside a GP sponsor on a deal-by-deal basis, typically through a special purpose vehicle. This provides the most control but also demands the most resources.
Fund of funds: LPs can invest into a fund of funds that sources and diligences co-investments on an LP’s behalf. This outsources more work but introduces an additional layer of fees.
Secondary funds: Secondary market funds purchase LP stakes in existing investments, sometimes involving co-investments. Less resource intensive for LPs but with less control.
Industry platforms: Emerging independent co-investment platforms aggregate opportunities from multiple GP sponsors for streamlined LP access. Offers breadth but requires due diligence.
When approached strategically, co-investing can enhance LP portfolios and partnerships with GPs. But the model also presents risks that require strong governance, resources and discipline. LPs must weigh the pros and cons to determine if a co-investment program aligned with their objectives and capabilities.