Co-investment in private equity refers to the practice where limited partners (LPs) invest directly in portfolio companies alongside a private equity (PE) fund manager. As a form of direct investment, co-investing is gaining popularity among LPs. This article will dive into the benefits and risks of co-investing to help LPs evaluate whether and how to adopt this investment approach.
Co-investment allows LPs to earn higher returns than regular fund investment
Many LPs choose to co-invest because they expect higher returns compared to investing in private equity funds alone. According to surveys by Preqin, the majority of LPs doing co-investments have achieved higher returns than their regular PE fund investments. This is because co-investments often come with reduced or no fees and carry charged by the fund manager. The cost savings directly translate to extra returns for LPs.
Co-investment provides LPs access to high quality deals with more certainty
Unlike direct investments sourced independently, co-investments allow LPs to leverage the deal flow and due diligence of PE fund managers. LPs essentially piggyback on the expertise of PE firms to access promising investment opportunities. This helps LPs mitigate the “blind pool” risk of fund investment where the future portfolio composition is unknown. With co-investments, LPs can proactively allocate to attractive deals in sectors, geographies and stages of interest.
Co-investing enables LPs to build closer partnerships with GPs
The co-investment relationship facilitates closer collaboration between LPs and fund managers. By working together on deals, LPs gain more insights into the GP’s investment strategy and portfolio management capabilities. This allows LPs to make more informed decisions on whether to commit to future funds of the GP. At the same time, LPs can strengthen their reputation as value-adding partners which helps attract GP interest.
LPs face adverse selection risk and need to be selective when co-investing
While co-investments offer many benefits, LPs need to be aware of adverse selection risk – the possibility that GPs do not provide their most attractive deals for co-investment. LPs should carefully evaluate each co-investment opportunity and align their interests with the GP’s. Turning down deals tactfully is important to sustain healthy long-term partnerships.
Successful co-investment requires strong deal evaluation expertise and quick decision-making
To capture co-investment opportunities, LPs must possess the expertise to quickly assess deals and make investment decisions, usually within weeks. This is very different from fund selection which could take months. LPs need the right processes and capabilities to take advantage of co-investments. Working with external advisors is an option if in-house expertise is insufficient.
In conclusion, co-investing allows LPs to boost returns, gain deal access and build GP relationships. With the right strategies and expertise, LPs can take advantage of co-investing as a value-adding investment approach alongside private equity fund commitments.