Private equity has been producing superior risk-adjusted returns, enticing investors to look no further than the asset class to get more bang for their buck. And, private equity fund sponsors are capitalizing on this to convince investors to put more dollars behind them. The strategy which is ticking all the right boxes for both private equity investors and sponsors equally in Europe and in the U.S., is co-investment. Such is the growing appetite that co-investments are becoming an important component of private equity investing.
Most co-investment involves “overage” — that is GPs offer additional investment opportunities to LPs. The co-investors invest in the overage investment opportunities alongside the lead fund in a separate co-investment vehicle in a relatively passive manner.
The need for LP co-investment by private equity funds generally has increased over the past six years. This has mainly been driven by the 2008 financial crisis and the bombardment of regulation since then, which has somewhat changed the fundraising landscape. For instance, it has affected hedge fund activity and investment/commercial banking activity in the private equity fund space, notably decreasing what were otherwise convenient sources of capital for GPs; it has brought about greater conservatism over the use of leverage in deals; and, fewer LPs have been taking up fund commitment opportunities, leaving some private equity firms struggling to raise the same size funds at the same pace they were once able to do. To continue doing the same size deals as in the past, more firms are offering co-investment opportunities to their LP base rather than going down the lesser preferred route of syndicating deals to other private equity houses.
By the same token, co-investments are beginning to take firm spots on LP private equity allocation strategies because of the potential to achieve greater returns and to have more control over investments. The potential to achieve greater returns is brought about in many ways, the most obvious being lower fees; LPs expect significantly reduced fees and carry from co-investments. In fact, most LPs will insist on no fees and no carry. In their view, making their co-investment dollars available to a GP, often at short notice, is a worthy trade-off, especially when GPs are compensated through the lead fund for managing the asset. “No fees” is more or less the accepted market practice. Co-investments also enable LPs to put more dollars behind their best private equity funds and the timelines to liquidity are much shorter than in a blind pool because there is only one deal to exit.
There is, however, one important consideration that LPs must give to co-investment opportunities, and that is whether they wish to have the discretion to opt in and out of such opportunities or whether LPs prefer to hand over that discretion to the GP.
The former requires LPs to have the infrastructure and resources in place to carry out the necessary due diligence and review the deal documents. The reality is that many LPs do not have an in-house team to achieve all of that, bearing in mind that the costs of doing so might offset any savings made on lowered fees. Saying that, LPs do not need to have the manpower to review the co-investment opportunity in great depth. Instead, stress-testing the GP's investment case, reviewing the GP's due-diligence summaries and checking that the transaction documents are as expected, is normally sufficient for the LP to decide whether it wants in or out. This complements the co-investment timetable where the GP usually only has a one-off opportunity to close the deal it has negotiated, presenting it to LPs on a take-it-or-leave-it basis. LPs that make their own co-investment decisions also use this as an opportunity to drill down the inner workings of a GP's deal investment process — something which is less accessible, or even more difficult to measure, when assessing a fund commitment opportunity. This helps them identify those GP relationships on which they want to focus and behind which they are confident in placing not only their co-investment dollars but also their fund commitments.
Of course, those LPs that do not have an in-house team to review co-investments prefer instead to outsource the co-investment decision to the GP. Here, the LPs will only really focus on vetting the GP, deferring to the GP's expertise on which investments to make with their co-investment dollars.
Co-investments are commonly structured through limited partnerships or limited liability companies that invest alongside the lead fund. This tends to be the case whether in Europe or the U.S. Overage co-investment vehicles will typically have fund-like provisions, but narrower investment/divestment parameters. Such vehicles can also be customized to a particular LP where the vehicle is a “fund-of-one.”
GPs, for their part, are concentrating on those LP relationships that can quickly react to a co-investment opportunity or that will cede co-investment decisions to them, are willing to defer to the GP's judgment on most governance and operation matters once the co-investment is made, and can realistically back them on their future funding needs. So much so that LP co-investments are increasingly featuring in GP marketing strategies along the lines that LPs will need to take part in a fund's first closing in exchange for co-investment rights (that is if LPs want to ensure they are able to co-invest on deals and that they are at the top of the GP's co-investor list). Overall, good co-investments can be the making of an LP-GP relationship. It will be interesting to see if LP co-investment becomes even more prevalent in the future.
Noel Ainsworth is partner in the London private investment funds practice of global law firm, Morgan, Lewis & Bockius LLP. This article was written with support from associate Samia Lone.