Since the Economic Recession of 2008, it has been more difficult for private equity firms to secure capital commitments from institutional investors and other wealthy individuals for prospective funds. One of the ways firms spark their fundraising efforts is allowing co-investment rights, normally to large institutional investors, which typically allow the institutional investors to directly invest in the target company alongside the fund.1 Negotiations over co-investment rights have picked up over the last year, as more and more institutional investors are demanding these rights in return for sizable investment in the fund.2 According to a recent survey, “…36% of private equity managers have received requests for co-investment rights from more than half of the investors in their latest fund.”3
Co-investment rights offer many advantages and disadvantages for LPs and private equity firms. Thus, each party must conduct negotiations carefully, and the pros and cons of co-investment rights should be weighed on a case-by-case basis. I have outlined some of the primary advantages and disadvantages of co-investments for LPs below, which may help explain why these rights have been so vigorously bargained for in 2013.
Advantages of Co-Investment for LPs
Co-investment rights offer many advantages to LPs, which explain why they have become so popular over the past year. There are three main advantages of co-investment rights for LPs: 1) reduction in fees, 2) increased returns, and 3) better control, transparency, and exposure.4
Because the institutional investors are providing an additional source of financing in the purchase of the portfolio company, fees are often waived or reduced.5 The standard management and performance fees demanded by private equity firms typically follow a 2/20 structure. That is, LPs are expected to pay a 2% management fee and 20% performance fee, known as carried interest. When institutional LPs undertake co-investments, their fees are often reduced to 1/10 or waived completely.6
Further, a principle motivation for LPs to negotiate for co-investment rights are increased returns.7 If LPs have the ability to directly invest in the portfolio company alongside the private equity fund, they receive the benefits of the private equity firm’s operational and investment expertise without having their returns diluted by high fees and the equity ownership of other investors.
Lastly, directly investing in the portfolio company will allow LPs to have “…better control of the investment, better transparency and an opportunity to gain direct exposure to new industries.”8 LPs may feel more comfortable with an investment if they have a say in the strategic direction of the company and are able to take a more hands-on approach.
Disadvantages of Co-Investment for LPs
Despite the advantages outline above, LPs must be cognizant of the downfalls of co-investment rights. The principle co-investment disadvantages for LPs are: 1) adverse selection, 2) more concentrated risk of their portfolio, and 3) the costs associated with providing some of their own management functions.9
One of the disadvantages that is often overlooked by institutional investors when fighting for co-investment rights is adverse selection.10 Adverse selection is the idea that private equity firms will be more willing to allow fund investors to secure co-investments rights for investments that are riskier or larger than the investments the firm would normally make.11 From a private equity firm’s perspective, allowing a direct investment by an LP reduces the risk to the firm’s fund and could supply a much needed source of financing if the investment is too large for the fund’s investment scope.
Secondly, co-investment concentrates the risk of the LPs portfolio.12 Since the LP will already have contributed capital to the fund, it is “doubling down” its investment in a sense. If the portfolio company performs poorly, then the co-investing LP will take more of a hit. LPs must carefully consider whether or not it is wise to bypass deploying excess capital elsewhere in order to better diversify their investment portfolios.
Lastly, and maybe most significantly, LPs that secure co-investment rights will have to deal with the increased management responsibilities that come with being a minority investor.13 LPs will be expected to have their own teams handle due diligence and provide comments on the investment once a deal in tentatively in place, which will likely result in higher costs to the LP and maybe even an investment in forming its own team to shoulder the workload.14 These costs could offset the savings from the reduced (or waived) management and performance fees. The increased managerial responsibilities of LPs could also be a drawback of co-investment rights from the private equity firm’s prospective, as LPs could attempt to rely on the firm’s due diligence efforts and/or attempt to influence strategic decision-making.15
In conclusion, from an LP’s perspective, co-investment rights not only offer plenty of benefits, but also several drawbacks. Attorneys, both those who represent institutional investors and those who represent private equity firms, must work with their clients to determine whether or not co-investment rights are something they would like to make a focus of negotiations.
Dechert, Co-Investment Heats Up, But Some Are Less Than Thrilled, Law360 (Mar. 19, 2014, 1:29 PM), http://www.dechert.com/files/Publication/9cf05f11-5d69-4118-8e33-1103d86dbb88/Presentation/PublicationAttachment/5717132c-9792-4933-9a16-1452f32348ff/Co-Investment%20Heats%20Up,%20But%20Some%20Are%20Less%20Than%20Thrilled.pdf. ↩
See generally, Antoine Drean, In Private Equity, the Popularity of Investing Alongside Managers – No in Their Funds – Soars, Forbes (Mar. 17, 2014, 8:09 AM), http://www.forbes.com/sites/antoinedrean/2014/03/17/in-private-equity-the-popularity-of-investing-alongside-managers-not-in-their-funds-soars/. ↩
Jennifer Bollen, Appetite for co-investment heats up, Financial News (Mar. 14, 2014), http://www.efinancialnews.com/story/2014-03-14/preqin-co-investment-private-equity-demand-supply. ↩
Dechert, supra note 1. ↩
Hillary Canada, Getting the Right Recipe for Co-Investments, Wall St J (Mar. 19, 2014, 3:30 PM), http://blogs.wsj.com/privateequity/2014/03/19/getting-the-right-recipe-for-co-investments/. ↩
Dechert, supra note 1. ↩
Canada, supra note 6. ↩
Dechert, supra note 1. ↩