Co-investment has become an increasingly popular approach in private equity and venture capital in recent years. As limited partners seek greater control over their investments while general partners aim to expand their capital resources, co-investments allow both parties to achieve their goals. This article will provide an in-depth look at co-investment, including key analysis on the motivations, structures, and best practices.With the growth of ‘shadow capital’ and LP interest in more customized fund structures, co-investment offers a middle path between sole fund investing and separate accounts that require greater oversight. For LPs, co-investing alongside trusted GPs creates alpha while minimizing fees. Meanwhile GPs gain efficient access to incremental capital and strengthen LP relationships. However, successful co-investment depends on rigorous valuation, governance, and portfolio construction by the Limited Partner. By judiciously leveraging external expertise and instilling robust internal processes, LPs can generate outsized returns from co-investments featuring their preferred investment attributes.
LP motivations for co-investing revolve around greater returns and strategic involvement
Several factors drive limited partner interest in co-investing alongside their general partners:
– Enhanced returns: By reducing or eliminating fees and carry, co-investments can boost net returns by up to 5% over regular fund investing for LPs. According to Preqin data, 80% of LPs with co-investing experience believe they have delivered higher returns versus their regular private equity portfolio. The cost savings and potential for alpha make co-investments highly appealing.
– Portfolio customization: Rather than investing blindly in an entire fund portfolio, co-investing allows LPs to cherry pick deals fitting their preferences. They gain exposure to underlying assets and sectors of greatest strategic interest. This provides valuable flexibility relative to fund constraints.
– Relationship building: Co-investing strengthens LP ties with their highest conviction GPs. It signals LP commitment and provides valuable capital for transformative deals. The transparency and joint participation in due diligence also builds trust and alignment.
– Control: By directly holding portfolio company shares rather than limited partner fund units, LPs gain more control over their investments. They can customize deal terms, information rights, exit timing, and other variables.
While sacrificing fees and carry, GPs benefit through efficient capital access and LP loyalty
Though general partners must forfeit certain economics, they still have compelling reasons to offer co-investment opportunities:
– Capital availability: By pooling capital with their LPs, GPs can pursue larger deals without breaching fund investment caps or maximum ownership limits. This provides access to opportunities requiring more firepower.
– Fundraising advantage: Providing co-investment rights boosts a GP’s appeal to LPs during fundraising. Investors value the additional access and flexibility co-investment affords them.
– Strengthened LP relationships: Partnership with LPs during co-investing fosters greater alignment and trust. The LP gains transparency into the GP’s operations. This helps secure re-ups and successor fund commitments.
– Portfolio diversification: Allowing LP co-investment enables GPs to syndicate ownership in portfolio companies. This diversifies their risk exposure.
– Incremental economics: Though management fees and carry are reduced on co-invested capital, GPs still earn returns on their own co-investment stake. The incremental profit can be meaningful.
Structuring co-investments properly is critical for both LPs and GPs
Two common co-investment structures, each with pluses and minuses, are:
– Direct co-investment: The LP invests directly in the target company alongside the GP fund. This provides the LP maximum flexibility and control over deal terms. But it requires greater oversight of portfolio management and exits. Valuation and governance rights must be negotiated carefully.
– Sidecar/parallel funds: A separate pool of capital is created for LPs to co-invest with the main GP fund. This simplifies execution for LPs, but reduces influence over deal terms. LPs must pay some management fee and carry, potentially misaligning incentives if different performance hurdles apply.
Best practices to optimize alignment in either structure include:
– Ensuring open and symmetric information flow between the LP and GP.
– Agreement on valuation methods, information rights, and governance.
– LPs securing protective rights like tag-along and drag-along clauses.
– Clear economics including reduced/zero fees and carry for LPs until an agreed hurdle return is reached.
For LPs, a prudent co-investment program features rigorous deal evaluation, consolidated portfolio monitoring, and adequate diversification. Blending co-investments across stages, sectors, geographies and vintages minimizes risk.
Success requires an LP build sound processes, governance and capabilities
To maximize long-term co-investment returns, LPs must:
– Institute robust governance policies that guide investment decisions, monitoring and risk management. This includes designating clear responsibility for oversight.
– Build a repeatable co-investment decision making process. With compressed diligence timeframes, standardized playbooks enable rapid, high conviction calls.
– Develop strong valuation competencies, underwriting skills and business judgement either internally or with qualified external advisors.
– Carefully screen GPs and offers for adverse selection, ensuring quality deal flow that warrants reduced economics.
– Construct a diversified portfolio reflecting strategic goals, emphasizing risk control alongside projected returns.
– Integrate co-investments into the overall private markets program, with regular reconciliation of performance and exposures.
– Hire investment professionals, or upskill in-house talent, with direct investing expertise from backgrounds like private equity, investment banking and corporate development.
With the right governance foundations, expertise, analysis and diligence, LPs can secure upside, alpha and influence through co-investment while strengthening partnerships with top GPs.
In summary, co-investment allows LPs to capture higher net returns and customize exposures while providing GPs with efficient capital for greater scale. When structured thoughtfully using best practices, the approach can strengthen alignment and LP-GP relationships. But successful co-investment requires LPs have robust processes, capabilities and governance to evaluate opportunities, construct diversified portfolios, and monitor performance.