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.