Co-investment in private equity refers to the practice of limited partners (LPs) directly investing alongside general partners (GPs) in an individual portfolio company, outside the scope of their commitments to the fund. It has become an increasingly popular way for LPs to gain more control and potentially higher returns. In a typical private equity structure, LPs commit capital to a fund managed by the GP. The GP then selects and manages the investments. With co-investing, the LP participates in funding a specific deal the GP sources, reviews, and monitors. This article will examine what co-investment in private equity entails, its advantages and risks, the mechanics of how it works, and key considerations for LPs exploring co-investment opportunities.
Co-investment provides LPs access to deals outside fund constraints
Unlike investing in a fund which sets investment criteria like geography, sector, and stage, co-investing allows LPs to cherry-pick attractive deals fitting their own mandate. It gives them increased exposure to deals they may not otherwise access due to fund diversification requirements or investment capacity limits. For example, an LP interested in late-stage tech may co-invest in a specific pre-IPO unicorn the GP oversees, even if the main fund cannot invest further capital in the company.
Co-investment offers potential for higher returns with lower fees
Co-investments are often structured with no management fees or carry charged to LPs, unlike traditional fund investments which charge ~2% in fees and 20% in carried interest. This fee reduction increases the LP’s net returns. According to Cambridge Associates, 80% of LPs reported co-investment returns exceeding those of their PE fund investments. Additionally, LPs may benefit from investing at a later stage than the GP fund, allowing them to pay a lower price and get greater upside.
The co-investment process involves extensive due diligence by LPs
The LP undertakes detailed due diligence on any co-investment opportunity presented by the GP. This includes assessing the investment thesis, financials, company management, risks, and projected returns based on the GP’s work. The LP must decide quickly, often within weeks, if it will commit capital and at what valuation. Once committed, the LP provides funding on the same terms as the GP and its main fund. While the GP handles operations, governance, and exit, the LP has visibility into the investment as a direct investor.
LPs should be cautious of adverse selection and portfolio overlap risks
GPs may offer co-investment opportunities they judge as riskier or less attractive versus deals reserved for their main funds. LPs should screen for adverse selection by the GP. Portfolio overlap is also a concern since co-investments may replicate existing fund investments. However, good opportunities still exist for LPs open to co-investing alongside top-tier GPs.
In summary, co-investment allows LPs to access specific private equity deals with potential for higher returns and lower costs but requires extensive due diligence. When executed prudently, co-investing provides limited partners more control and greater exposure to attractive investments alongside their fund commitments.