Equity co-investment refers to the direct investment in a single company by limited partners(LPs), along with the fund’s general partner(GP). It has become an increasingly attractive approach of alternative investment for LPs in recent years. The reasons are obvious: higher return, lower cost, closer GP relationships and more investment opportunities. However, equity co-investment also faces some challenges like adverse selection risks and lack of capabilities. This article will analyze pros and cons of equity co-investment and provide suggestions for LPs to better utilize this investment approach.
Higher return is the primary motivation for LPs to choose equity co-investment
Most LPs participate in equity co-investment are aiming for higher returns compared to investing in GP’s main funds. According to survey from Preqin, over 80% of LPs have achieved better performance through equity co-investment. The return uplift ranges from 2% to as high as 10%. This significant increase of return mainly comes from the fee and carry reduction. GPs usually waive or largely reduce fees and carry for equity co-investment deals. The saving of 2% management fee and 20% carry directly translates to higher return.
Lower cost is another key driver for the popularity of equity co-investment
In addition to higher return, the reduction of management fees and carried interest also leads to lower investment costs for LPs. According to Mckinsey, the management fees and carry for equity co-investment deals are 49% and 48% lower compared to main funds. With billions of capital invested in private equity each year, even 1% to 2% fee saving means tens of millions of dollars. Furthermore, some GPs also provide deal fees discount to LPs for equity co-investment. So the significant cost saving is an obvious advantage that attracts LPs.
Equity co-investment enables LPs to access more high quality deals
Beyond return and cost benefits, equity co-investment also provides LPs opportunities to invest in more quality deals. The challenges of being a direct LP investor are the lack of capabilities and deal flows. Equity co-investment perfectly complements these weaknesses. LPs can leverage capabilities of GPs to evaluate deals, conduct due diligence and monitor investments. More importantly, equity co-investment expands LPs’ access to GPs’ full deal flows. LPs can cherry-pick attractive investment opportunities that match their preferences and portfolio needs.
Stronger LP-GP alignment is another merit of equity co-investment
Participating in equity co-investment together with GPs enables closer relationships between LPs and GPs. It gives LPs better visibility into GPs’ operations and investment decision process. The enhanced transparency and information sharing foster greater LP-GP alignment. Studies show that LPs who frequently co-invest with GPs have higher probability to commit to the GPs’ future funds. The strengthened partnership ensures LPs’ access to more quality deal flows and investment opportunities.
Adverse selection risk and lack of capabilities are main challenges for equity co-investment
However, equity co-investment also faces some notable risks and challenges. The most significant one is adverse selection risk. GPs may cherry pick best deals for their main funds and give inferior investments to LPs. Without sufficient capabilities, LPs may struggle to identify adverse selection behaviors. Another key challenge is the lack of experience and expertise in direct investing. Making investment decisions in short time frames requires different mindset and skills compared to fund investing. Without preparations, many LPs fail in equity co-investment due to the lack of experience and capabilities.
In conclusion, equity co-investment provides an effective approach for LPs to achieve higher returns, lower costs and broaden investment opportunities. However, LPs need sufficient capabilities and mitigation of adverse selection risks to extract full values. With the right strategy and execution, equity co-investment can become an important tool for LPs to optimize portfolio construction and achieve superior performance.