Co-investment funds have become an increasingly popular investment approach in recent years. As limited partners look for ways to enhance returns and develop direct access to deals, co-investing alongside established fund managers provides an attractive option. In this article, we will explore common co-investment structures, motivations for limited partners and general partners, and keys to successful implementation of a co-investment program. With over $100 billion in co-investment capital now flowing into private equity deals annually, understanding the co-investment landscape is crucial for investors looking to tap into this burgeoning asset class.
Common co-investment structures
There are several ways limited partners can implement a co-investment program. The most straightforward is via deal-by-deal co-investments, where the LP reviews opportunities alongside the main fund and opts into specific deals. This provides maximum flexibility but also requires significant resources to evaluate deals. Another approach is through a co-investment vehicle or sidecar fund managed by the GP, where LPs commit capital that is deployed opportunistically across the main fund’s deals. While the LP gives up some control, it benefits from the GP’s deal sourcing and due diligence. Syndicating a portion of each main fund deal is another popular structure, providing access for LPs but less discretion over individual transactions.
Motivations for general partners and limited partners
For general partners, co-investment programs provide additional capital to fund larger deals or free up main fund reserves for follow-ons. They also deepen alignment and relationships with LPs. On the LP side, co-investing provides lower fees compared to main fund economics as well as potential for enhanced returns. It also offers more control over deal selection, often in sectors or regions of interest. However, LPs need sufficient operational capacity and access to deal flow to implement successful co-investment programs.
Keys to effective implementation
While co-investing offers advantages, it also comes with potential pitfalls. LPs should have clearly defined investment criteria, rigorous due diligence protocols, and the ability to make quick decisions when co-investment opportunities arise. Maintaining a focused co-investment portfolio is also key – over-diversification can erode returns. Legal terms should provide adequate minority investor protections while allowing for flexibility to participate. Above all, alignment with trusted GPs is critical – co-investing should strengthen, not strain, LP/GP relationships.
The outlook for co-investment
Given the favorable liquidity environment and need for alternative sources of alpha, limited partners are expected to continue increasing allocations to co-investments. As a specialist capability, some LPs are building dedicated co-investment teams. However, the space is also seeing more crossover interest from real estate, infrastructure, and other private market investors. With competition increasing, investors able to provide meaningful strategic value-add will be best positioned to partner with top-tier GPs and gain access to the most attractive co-investment opportunities.
Co-investment provides a way for LPs to enhance private equity returns, but requires careful structuring, rigorous due diligence, trusted GP relationships, and adequate strategic value-add to yield success.