Co-Investing 101: A Guide to Partnering with Top Private Equity Firms

Introduction to Private Equity Co-Investment

Private equity co-investment involves partners (LPs) directly investing in companies alongside equity firms outside of the usual fund setups. In an investment setup, LPs provide capital for a specific deal, project, or business rather than spreading their investments widely across a portfolio of companies via a private equity fund.

Co-investments differ from fund investments in several key ways:

  • Deal-by-deal basis: Co-investments allow LPs to invest in specific opportunities on a deal-by-deal basis rather than committing capital to a blind pool fund. This provides more control over investment selection.
  • Direct ownership: With co-investments, LPs invest directly into the target company and receive ownership privileges equal to those of private equity firms. In a fund structure, the general partner (GP) controls investments.
  • Fees: Co-investments avoid the typical 2% management fee and 20% carried interest charged by GPs on fund investments, resulting in lower fees overall.
  • Governance: Limited partners (LPs) have influence and involvement in governance, giving them the opportunity to directly discuss terms with the company.
  • Pooling of capital: This occurs in funds where LPs combine their capital for investment by a partner (GP).

The co-investment terms are individually negotiated for each deal, offering advantages compared to committed fund structures.

How Co-Investment Works

Engaging in investment chances offers investors, such as pension funds, insurance firms, endowments, family offices, and affluent individuals, the opportunity to invest directly in enterprises alongside an equity fund. Unlike investing funds into an equity fund without significant influence, co-investing enables investors to select the companies they wish to invest in and collaborate with the primary private equity firm or general partner.

Here are the key steps involved:

  • GP sources potential deals and performs initial due diligence.
  • GP approaches interested LPs, providing information about the deal.
  • LP conducts their own due diligence and negotiates investment terms.
  • Legal documentation is drawn up, outlining ownership stakes and governance rights.
  • LP invests capital directly into the company alongside the main fund.
  • LP acts as a direct shareholder and may participate in strategic planning.
  • At exit, LP receives distributions and returns directly.
  • Investing together allows for flexibility. The opportunity to invest money alongside trusted general partners.

This offers flexibility compared to being confined to a fund size.

Key Benefits of Co-Investing

Co-investing alongside private equity funds provides limited partners several advantages compared to only investing through traditional fund structures.

The key benefits of co-investing include:

Higher Returns

When individuals invest directly in companies using a fund, they have the opportunity to gain a share of the profits from successful investments. By avoiding the 1.5-2% management fee and 20% carried interest on earnings that private equity funds charge, co-investors can keep more investment returns for themselves.

Lower Fees

As mentioned above, co-investors avoid paying the substantial management fees and carried interest typically charged by PE funds. Co-investments often have performance fees or involve minimal fees, boosting net returns. Fund managers may charge a small transaction fee on co-investments, which is nominal compared to traditional fund fees.

More Control and Transparency

With co-investments, LPs negotiate deal terms directly with the lead PE sponsor and company management. This provides more control over investment decisions than being a limited fund partner. Co-investors also gain more transparency into the investment thesis, company operations, exit planning, and other aspects.

Direct Access to Deals

Co-investing offers an opportunity to access investment options that individual investors may not typically encounter. By utilizing the expertise and research of equity firms co investors can participate in opportunities usually reserved for investors in equity funds. In essence, the potential for profits, fees, greater autonomy, and direct involvement in deals make co-investing a choice for eligible investors.

Risks and Challenges of Co-Investing

Co-investing alongside private equity funds into operating companies comes with a unique set of risks and challenges that LPs should consider.

Requires Significant Resources

Investing in a fund is not the same as co-investing as the latter requires dedicating resources to finding, assessing, negotiating, and overseeing deals. Limited Partners (LPs) expect investment teams to have expertise in investing in companies across sectors, regions, and deal types. This is a major undertaking requiring significant fixed costs. Small and mid-sized LPs may lack the capabilities to implement an effective co-investment program.

Higher Risk Profile

Co-investments are often in companies requiring expansion capital or acquisitions. These types of investments often involve higher levels of risk compared to buyout funds that target established profitable businesses. Without research and analysis, co-investments may result in overpaying or backing ventures with outcomes. The responsibility for conducting due diligence rests on the co-investor.

Governance Challenges

Unlike a fund where the GP makes decisions, co-investors must negotiate governance rights directly with companies. This could lead to potential conflicts with management teams or other investors. LPs must ensure they receive adequate control provisions, shareholder rights, and access to information. Passive investors and LPs lacking experience on company boards could struggle to protect their interests.

In summary, co-investing requires dedicated resources, carries higher risk, and poses governance challenges. LPs must weigh these factors against the potential benefits. Thorough due diligence and appropriate staffing are crucial to mitigating the unique risks of co-investing.

Structuring Co-Investment Deals

Negotiating Legal Agreements

Key considerations for legal agreements include:

  • Shareholder rights: Co-investors will want to ensure they receive ownership privileges equal to other shareholders, including the private equity sponsor. Preferred stock versus common stock will impact governance rights.
  • Board seats: Larger co-investors often negotiate the right to appoint a director to the company's board. This provides oversight and influence.
  • Information rights: Legal agreements should clearly specify financial reporting requirements and allow co-investors access to relevant documents and records.
  • Liquidity: Terms for potential exit events like IPOs or acquisitions should be established upfront. Drag-along and tag-along clauses are important to examine.
  • Other rights: Agreements may provide co-investors with inspection, preemptive, and registration rights. Voting requirements for major transactions should be clear.

Negotiating favorable legal terms upfront is crucial to protect the co-investor's interests in the company.

Tax Considerations

Investing in co-opportunities in private equity involves pooling resources with others. This type of investment can have implications on the tax treatment of your investment. If you opt for a minority controlling stake (indicating limited influence over the company decisions) you may enjoy tax advantages at the capital gains rate which is typically lower compared to passive investments where you earn interest or dividends without active involvement.

Deal Size and Ownership

Investing alongside others in equity often involves committing from $10 million to $100 million although certain institutional investors might exceed the $100 million mark. Normally co investors hold a minority interest in the company typically falling within the range of 10% to 30%.

Co investors should diversify their investments and refrain from allocating a large portion of funds into a single investment opportunity. Creating a portfolio consisting of 8-12 co-investments helps reduce risks. When discussing deal sizes and ownership shares, co-investors should consider their investment objectives, risk tolerance, and target returns.

Implementing a Co-Investment Program

Successfully executing a co-investment program requires building out the right resources and processes. LPs pursuing co-investments should take the following steps:

Building a Dedicated Team

  • Seek out investment experts who excel at identifying, evaluating, and securing co-opportunities. These experts must possess robust financial analysis and thorough research skills.
  • Bring on board professionals with a background in structuring investments or collaborative investment agreements to oversee contracts and deal negotiations.
  • Designate relationship managers to foster and maintain strong relationships with general partners, as GPs provide access to deals.
  • Consider adding operations experts to oversee portfolio companies post-investment, as co-investors often take active governance roles.

Developing a Co-Investment Strategy

  • Define investment criteria, including size, industry, geography, and deal attributes. This guides the pursuit of relevant opportunities.
  • Set return hurdles appropriate for the direct exposure and illiquidity of co-investments. Targets should exceed fund investments.
  • Establish governance policies for investment decision-making, portfolio monitoring, and risk management.
  • Create guidelines for partnering with GPs, syndicating with other LPs, and direct investments.

Portfolio Construction Approach

  • Determine target allocation to co-investments relative to other asset classes.
  • Diversify across GPs, industries, geographies, and vintages to mitigate risk.
  • Size positions according to company attributes and expected return profile.
  • Reserve adequate liquidity for potential capital calls and follow-on investments.

LPs must make significant organizational changes to have co-investment capabilities comparable to PE firms. The strategy, team, and processes determine success.

Co-Investing for Specific Investor Types

Co-investment opportunities attract a range of investor types who can benefit from this model in different ways. Two of the most active co-investors are family offices and institutional investors.

By Family Offices

Family offices have emerged as major players in private equity co-investments. Family offices' flexible investment mandates and long time horizons make co-investing attractive. Family offices pursue the equity co-investment re-investments for several key reasons:

  • Direct access to deals: Co-investments allow family offices to gain direct exposure to promising companies that top-tier PE funds are investing in. This gives them access to deals they likely couldn't source independently.
  • Lower fees: By investing directly, family offices can avoid the management fees and carried interest typical of PE fund structures. This results in lower costs and potentially higher net returns.
  • Greater control: With co-investments, family offices negotiate terms directly with the lead PE sponsor and company management, providing more oversight than being a limited partner in a fund.
  • Different opportunities: The variety of investment options includes platform investments, additional investments, recapitalizations, growth equity and other special opportunities.
  • Spreading out investments: Collaborating on investments enables family offices to spread their investment portfolio across sectors, geographic regions, investment types, and years.

In essence, co-investment empowers family offices to execute an adaptable private equity approach customized to their goals. It has emerged as an element in equity fundraising and market investing for numerous sophisticated family investment entities.

Co-investing enables family offices to implement an active and flexible private equity strategy tailored to their specific objectives. It has become essential to private equity fundraising and market investing for many sophisticated family investment firms.

By Institutional Investors

Institutional investors see the value in co-investments for a variety of reasons:

  • Increase exposure to top-tier GPs: Co-investment allows institutions to deploy more capital with their favorite PE fund managers, expanding the relationship beyond the constraints of fund commitments.
  • Lower fees: Institutions can avoid paying the typical 1.5-2% management fee, and 20% carried interest charged by PE funds. Co-investments offer reduced fee structures.
  • Direct access: Institutions negotiate co-investment terms directly rather than being passive limited partners in a fund structure. This provides more control and transparency.
  • Tactical allocation: Co-investments allow tactical allocation to specific companies and sectors, while funds provide broad diversification. This complements fund investments.
  • Portfolio construction: Institutions utilize co-investments for portfolio management, like increasing exposure to specific strategies or markets.

Conclusion and Key Takeaways

The Pros and Cons of Co-Investing

Some of the key advantages of co-investing include:

  • Access to proprietary deals from top-tier GPs
  • Ability to deploy more capital into select investments
  • Lower fees compared to traditional fund structures
  • More control over deal terms, governance, and exit
  • Potential for outsized returns compared to fund investments

However, co-investing also comes with drawbacks, such as:

  • Significant resource requirements for sourcing and diligence
  • Need for experience in direct/co-investing
  • Increased investment risk
  • Governance complexities
  • Potential for conflicts of interest with GPs

Evaluating Co-Investment Opportunities

Investors should focus on:

  • Track record and reputation of the lead GP
  • Investment merits of the specific deal
  • Risk-return profile and fit with investment objectives
  • Governance and information rights
  • Deal economics - ensure reasonable fees and carry compared to effort and risk
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