Co-investment has become an increasingly important part of the private equity landscape in recent years. As a form of direct investing, co-investment allows limited partners (LPs) to invest directly into deals sponsored by general partners (GPs) alongside the GP’s main fund. By co-investing, LPs can gain exposure to specific deals they find attractive while avoiding management fees and carried interest. In this article, we will explore what exactly co-investment is, why LPs pursue it, the benefits and challenges, and how the co-investment market has grown.
Co-investment defined
Co-investment refers to when an LP invests directly into a company, asset, or project alongside the GP’s private equity fund. The GP sources the deal and undertakes due diligence as usual, then may offer co-investment rights to LPs. This allows the LPs to invest their own capital directly into the asset rather than through the fund. While the GP’s main fund will still take a majority stake, the co-investors participate in the equity upside. Co-investments are typically structured as a single asset vehicle rather than a pooled fund.
Motivations for LPs
According to surveys, the main drivers for LPs to pursue co-investments are to enhance returns and reduce fees. By investing directly, LPs can participate in the deal economics without paying the typical 1.5-2% management fee or 20% carried interest. This can result in a management fee savings of up to 50%. LPs also hope to achieve better returns by cherry-picking specific deals rather than investing in a blind pool. Co-investing may additionally strengthen LP-GP alignment and relationships. On the GP side, offering co-investment rights help establish a positive track record and differentiate their fund in a competitive fund raising environment.
Benefits of co-investing
The potential benefits of co-investing for LPs include: – Improved returns from lower fees/carry and investing only in attractive deals – Investment control instead of blind pool risk – Strengthened relationships and alignment with GPs – Co-investment at an earlier career stage than carry – Highly flexible capital for portfolio management – Potentially smoother cash flows and J-curve – Enhanced knowledge of markets, sectors, GPs – Opportunity to build direct investing capabilities
Risks and challenges
However, co-investing also comes with potential pitfalls: – Availability of deals may be limited for newer LPs – Requires strong due diligence capabilities vs. relying on GPs – May receive adverse selection of deals from GPs – Adds complexity in portfolio management – Risk of overpaying for assets without fund economics – Potential conflicts of interest with GPs – Regulatory burden may still be high – Tax treatment may not be optimal – Executing deals on short timelines can be difficult
Rapid growth of co-investing market
The co-investment market has experienced explosive growth, rising from $10 billion in 2000 to over $100 billion in 2017 globally, based on Preqin data. This reflects the search for yield and desire for lower cost direct exposure by LPs. In fact, a majority of LPs now rank co-investments as one of their top priorities. With LP demand increasing and GPs responding with more co-investment offerings, this market is poised for continued expansion.
In summary, co-investment represents an important way for LPs to invest directly into private equity deals alongside a GP fund, providing potential benefits but also challenges. As LPs seek to reduce fees and gain more control, co-investing has moved into the mainstream.