Co-investments — typically offered on a no-fee no-carry basis — have become an incredibly sought after private equity investment opportunity, with an entire cottage industry built around them.
But are co-investments really "free"?
Put another way, are the benefits of some co-investments outweighed by the drawbacks, and are there better alternatives for traditional limited partners?
Free co-investment deals sound great in theory: A limited partner gets to invest in a direct deal underwritten by a top-tier general partner without paying the standard private equity fees, retains the ability to determine their precise capital deployment and sees mitigation in the J curve. The trouble for most smaller and midsize limited partners, say investors looking to write checks in the range of $50 million to $1000 million, is that the reality is far less sanguine.
1. Most LPs will never get to see the best co-investment deals. LPs typically only get to co-invest if a deal is so big that a private equity fund decides not to fund the entire deal itself. So right off the bat, co-investment in the context of private equity inherently means someone has already passed on the deal.
In fact, there is an entire investment food chain fighting for co-investment opportunities with the biggest investors getting the best look at deals. Most family offices or smaller institutional investors are only seeing deal opportunities that have been passed over by the bigger players in the market.
2. "Free" co-invest deals actually can be quite costly. Even though an LP doesn't have to pay for the co-investment in a particular deal, there are many fees along the way that dim the appeal of these opportunities. Monitoring fees are a particularly insidious and costly example of fees for which LPs are on the hook, even in a "free" scenario. Private equity firms charge their portfolio companies monitoring fees that can cost the company millions of dollars each year. General partners have come under increasing scrutiny by the Securities and Exchange Commission for fee abuses and fraudulent practices related to monitoring fees, among other practices, and have successfully litigated such cases against some of the bigger private equity players.
According to a recent report issued by the Center for Economic and Policy Research, in 2015, a large asset management firm paid $30 million to settle an enforcement action for misallocating expenses in failed buyout deals while another paid $39 million to settle charges of improper fee allocation.
In fact, limited partners are distinctly disadvantaged by an overall lack of fee transparency. According to the same report, private equity GPs have repeatedly misallocated private equity firm expenses and inappropriately charged them to investors; have failed to share income from portfolio company monitoring fees with their investors, as stipulated; have waived their fiduciary responsibility to pension funds and other LPs; have manipulated the value of companies in their fund's portfolio; and have collected transaction fees from portfolio companies without registering as broker-dealers as required by law.
An LP, therefore, needs to consider all of these ancillary fees and the related tactics when evaluating the cost of a "free" opportunity.
3. Most LPs don't have the infrastructure to co-invest. In addition to these costs, many LPs simply don't have the infrastructure to take advantage of co-investment opportunities because they lack the in-house capacity or expertise to screen the opportunities, perform the due diligence, negotiate term sheets, etc. As a result, many of these LPs are having to bolster staffing with analysts who can provide this support, further adding costs to a co-investment process.
Exposing the hidden costs in 'free' co-investment
Let's take an example.
Consider a private equity fund looking to buy an industrial company and raise a portion of the funds in co-investments. Just for starters, for most transactions there's a competitive bidding process, and bankers take fees — as much as 7.5% or more — right off the top. Add into that transaction fees a fund might take for originating the deal.
Then, in order to have access to the co-investment in the first place, you have to be an LP of a certain size in the private equity fund, which means you have committed capital to the PE fund on which you are typically paying 2-and-20 fees and that has a 10-year lockup.
Finally, as mentioned earlier, given the pecking order of the food chain, smaller investors will most likely not get to invest as much as they would like (if at all) into one of these opportunities.
Per the Center for Economic and Policy Research report, even when private equity firms do share fee income with their investors, they retain billions for themselves.
While the "free" co-investment might overall reduce the 2 and 20 fees investors pay to invest in a private equity fund, the combination of (1) the likelihood that they aren't seeing the best deals; (2) the cost of the long-term committed capital; and (3) that the investor probably won't get to invest as much as they would like, strongly suggests smaller and midsize LPs are better off looking elsewhere for co-investment deals that can provide the returns they seek.
For these reasons, simply relying on existing GP relationships to source compelling co-investments probably isn't the optimal way to maximize returns.
There are alternative sources to sourcing co-investments from traditional private funds including pledge funds, specialty brokers, placement agents, independent sponsors, merchant banks, family office syndicates and direct investment platforms. Although each is configured differently and range in quality, these options can allow investors to gain access to more compelling co-investment opportunities.
Jeff Baehr is founder and CEO of RueOne Investments, New York. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.