Over the last several years there is a rising trend in the Private Equity market; After the financial crisis more and more General Partners have been choosing to offer co-investment opportunities to attract the best LPs. For more than a decade, more than $175 billion has been generated in co-investment fund investments among 1,101 funds. A co-investment allows the LP to participate alongside the fund manager’s main fund in certain underlying portfolio firms.
According to Preqin, co-investment funds have outperformed or at least remained consistent with direct private equity funds in terms of median net IRR.
In order to understand the motives, the opportunities and the challenges that a co-investment entails, we need to begin the analysis from the initial offering of a co-investment.
In the private equity market, the existence of trust between GPs and LPs is an essential ingredient for a successful fund “recipe”. With co-investments GPs give LPs the chance to have a more thorough look at the due diligence process of the fund manager and accurately assess the portfolio “fit”. At the same time, the two sides strengthen their relationship in a climate of mutual respect and transparency.
In addition, co-investments allow the investors to enhance the diversification of their portfolios and make more prudent investment choices. At the same time, when a General Partner believes that a specific investment opportunity requires a large capital contribution or requires excessive exposure to a certain sector, co-investments can be used to cover any residual investments.
The structure of a co-investment is such that maximizes the potential returns of the investors. GPs are offering favorable fees and sometimes there is a no fee agreement, something that increases the appetite of LPs for co-investments. Additionally, Limited Partners have increased control as they have the ability to select and focus on investments that are more aligned with their mandate and portfolio goals.
A characteristic phenomenon in the private equity market is the J curved shape of a Private Equity fund investment performance over the years. In the initial years of a fund’s investment the returns are negative and the period where the breaking point occurs varies. Among other solutions for this, a 20-30% co-investment allocation has been proven to reduce the J-curve by 12-18 months. Something like that could also result in decreased overall portfolio duration. With co-investing, the private equity market is becoming more functional as funds’ performance is enhanced from the early stages and the deployment of capital is performed in a more efficient and timely manner.
As co-investment is a form of a new relationship, there are some challenges and considerations that both parties need to keep in mind to make this arrangement work.
Firstly, as General Partners do not offer co-investment opportunities to everyone, LPs need to satisfy certain requirements so that they are a more “attractive” co-investing partner. GPs have specific ways that operate and usually act fast and deploy capital on time. Therefore, LPs should have speedy responsiveness and respect the GP’s time and process. Also, investors have to be decisive when committing to a co-investment agreement because the deal depends on their participation. In terms of vintage and sector, fund investment is more diverse and thus LPs should be certain that they want to move forward with a co-investment that normally has different risk parameters. Finally, in the private equity market, reputation is a very crucial factor and LPs should aim for timely and precise execution of the co-investment agreements so that they can develop their credibility and forge strong relationships with their GP partners.
As the co-investment market matures the two parties will gradually overcome these challenges. The private equity market not only becomes more complicated, with the growth of different structures but also more transparent. Co-investing is becoming a part of the fundraising campaign, a key step of the pre-marketing process. We, at c*funds, recognize all the multiple benefits a co-investment can bring for all the participating parties and we encourage fund managers to offer co-investment opportunities as it is a unique way to attract the best limited partners and create lasting relationships. But, as co-investments have high value the offer should not be to anyone, but it has to come with well-curated entry criteria for the LPs.
It is very exciting to see all the latest developments in the Private Equity market, and how they bring more information flow and flexibility. It is a certainty that co-investments are not a fleeting trend but a useful tool that has the potential to transform the PE landscape.
This article was written by Giannis Filandros.