Direct co-investment in private equity projects has become an increasingly popular approach for limited partners (LPs) to participate in private equity investments alongside general partners (GPs). As an alternative investment strategy, direct co-investments allow LPs like sovereign wealth funds, pensions, endowments and family offices to pursue higher returns compared to sole fund investments, while avoiding excessive fees and gaining more control over their investments. This article explores the definition, benefits, risks and selection criteria of direct co-investments in private equity, providing insights for LPs looking to enhance returns and connect with top-tier GPs through this efficient investment route.
Direct co-investments offer the twin benefits of lower costs and faster cash flows
A major impetus for LPs opting for direct co-investments is the prospect of higher net returns. By co-investing alongside GPs, LPs can save on recurring management fees and carried interest, which are usually set at 2% and 20% respectively in traditional private equity funds. The cost savings directly translate to extra returns, making direct co-investments a more efficient way to deploy capital. Moreover, direct co-investments allow LPs to bypass the J-curve effect typical in blind pool funds, realizing gains earlier during the 5-8 year investment cycle. According to HarbourVest Partners, LPs can recover over 50% of costs within the first 5 years through co-investments, compared to a longer waiting period for cash flows from regular fund investments.
Direct co-investments provide transparency into quality assets and closer GP relationships
Unlike blind pool funds where the underlying assets remain unclear during fundraising, co-investment opportunities usually arise when GPs have identified concrete deals in need of additional funding. By evaluating each project individually, LPs can conduct thorough due diligence and negotiate better terms to match their return targets. The transparency and discretion also help mitigate adverse selection risks from GPs. Moreover, co-investing fosters closer alignment between LPs and GPs, allowing the former to observe the investment process directly. As LPs become valuable partners through repeated co-investments, GPs are incentivized to share more proprietary deal flows in the future.
However, direct co-investments require extensive sourcing networks, capabilities and swift decision-making procedures
While promising higher returns, direct co-investments also come with several caveats for LPs. First and foremost, LPs need wide access to deals from GPs to capitalize on co-investment chances in a meaningful scale, which demands extensive networking and differentiated value propositions to GPs. Next, thorough investment expertise across sectors, geographies and asset types is essential for sound decisions within the compressed diligence timeframe imposed by GPs. Finally, efficient internal decision-making processes have to be established beforehand, to meet GP deadlines for approving co-investment participation. Therefore, LPs must assess if they possess the requisite infrastructure and skill sets before engaging extensively in direct co-investments with GPs.
In conclusion, direct co-investment presents an attractive route for LPs to enhance private equity returns through cost savings and timely cash distributions, while benefitting from asset transparency and closer GP partnerships. However, sourcing viable projects, demonstrating investment competence and making quick decisions are also imperative for success.