Co-investment has become a very popular alternative structure for investors seeking investment opportunities in the private equity (PE) market. To form co-investment vehicles, PE funds (also referred to as general partners [GPs] or sponsors) and investors (also referred to as limited partners [LPs] or co-investors) enter into partnerships to invest in separate companies (as opposed to direct investments in portfolio companies).
The structure of the co-investment vehicle varies based on the requirements of the parties involved. Typically, once a PE fund enters into a co-investment deal, it sets up a special-purpose vehicle (SPV) to pool co-investors’ capital and invest in target companies.
According to McKinsey report Global Private Markets Review 2018: The rise and rise of private markets, the value of global PE co-investment deals reached USD104bn in 2017, over double that in 2012. Furthermore, the number of LPs making co-investments grew from 42% to 55% during that period. Yet, proportion of LPs making direct investments (without co-investment) grew just 100bps, from 30% to 31%, during the period, indicating higher demand for co-investment vehicles across LPs and GPs. According to another McKinsey report, titled Global Private Markets Review 2019: Private markets come of age, demand for PE co-investment significantly outstrips opportunities provided by GPs, suggesting that co-investment opportunities are in short supply. The primary goal of co-investing is no different from that of any other investment method, which is to enhance returns of the overall portfolio. There are various benefits for both parties.
Benefits for investors
One of the key selling points of co-investments for LPs is lower management or carried-interest fees relative to fund investments, since unlike in the case of the traditional PE-fund structure, LPs do not have to pay any incremental management fees to GPs. In addition, the average difference between gross and net returns for PE funds has always been substantial; therefore, even a small allocation to co-investing could improve the returns and generate additional value for LPs. The other benefits are the potential for higher returns, shortened J-curve due to immediate capital deployment, more effective risk management and more flexibility and control while constructing a portfolio. In addition, co-investing helps investors who do not have the knowledge required to invest in certain jurisdictions by allowing them to collaborate with domestic PE funds.
Benefits for sponsors
For GPs, co-investment offers various opportunities, including the ability to enhance their own deal-making capabilities by deploying more capital, without long-term commitments; the flexibility to execute large transactions by accessing a larger pool of capital; facilitate relationships with other important investors outside of the constraints of the funds and increase the number of transactions in which they can participate.
Despite all the advantages of co-investing, there are some obvious challenges and risks, such as the risk of adverse selection, i.e., although co-investing reduces fees, it does not guarantee higher returns. Another drawback is that co-investors lose the flexibility to choose the co-investment opportunities in which they want to participate; instead, they participate by default in all co-investment opportunities chosen by sponsors. Furthermore, although the prospects for co-investing look bright currently, given the significant differential versus management fees of large PE funds, this advantage could narrow if PE funds’ management fees start decreasing.
Co-investing has become a very popular option in recent times. It is important, however, for investors to be clear about the objectives and Investment rationale of a co-investment program, which are very critical to its success. Nevertheless, the evolution of co-investing is a welcome development for the PE market and benefits investors and organisations alike. As private markets continue to gain flexibility, depth and sophistication, it will be interesting to observe how the market for co-investments evolves; meanwhile, it also remains to be seen whether this evolution will be a headwind or tailwind for the economic landscape of the future.
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