Co-investment: No longer a free lunch

Limited partners have cottoned on to co-investment as a way of compressing fees and taking greater control of their private equity programmes.

Last week China Investment Corporation highlighted the trend in its annual report, saying it had increased its share of co-investments in a bid to counteract the “ever-growing downside risks” in global markets. It is far from alone.

When thinking only of fees, co-investing makes sense. If an investor wants to commit $200 million to a private equity fund that charges a 2 percent management fee and 20 percent carry, it's better to commit only $100 million to the fund and keep the remainder to co-invest at no fee, effectively lowering the overall fee structure to 1 percent and 10 percent respectively.

But this is becoming more difficult; fund managers are increasingly charging fees or carried interest when they can. Nearly a third of 62 private equity firms recently surveyed by placement agent MVision Private Equity Advisers and the London Business School said they were charging fees on co-investment on a case-by-case basis.

Another survey of 179 GPs conducted by Palico found that 51 percent said they were charging fees or carry on co-investments. Around 30 percent of those that did not intended to do so in the future.

“GPs with strong track records are increasingly looking to charge LPs carry on co-investments,” says Michael Saarinen, counsel in the private investment funds practice at Goodwin Procter. In some cases, he adds, they may reduce co-investment carry for LPs if they exceed commitment thresholds or they participate in the main fund’s first close.

This makes sense; GPs should not be expected to work for free. As one GP recently put it, they are in the private equity business to make money for their LPs and themselves. And while co-investments can benefit GPs – allowing, for example, to go beyond their typical investment size range – co-investments are typically granted at the behest of LPs.

For LPs, lowering fees is not (and should not be) the only reason to pursue co-investment. The strategy puts more control in the LPs’ hands to overweight their portfolio towards a specific sector or geography, or to more closely manage the pace of investment. Some LPs use it as an early stepping stone towards direct investing, or simply as a way of “doubling down” with their favourite general partners.

However, the way GPs charge fees for co-investments is still all over the place, according to David Goldstein, a partner with DLA Piper.

“The market practice regarding co-investment terms is changing rapidly and there's no consistent approach on fees charged,” he says. The management fee can range from zero in the case of emerging managers or as much as 1.5 percent for established managers with a track record of making co-investments available to investors, he noted. Carried interest could range from nothing to 20 percent.

“Investors have traditionally pushed for a no-fee basis, but the largest managers are able to charge fees and it has become an important element in the relationship between these managers and their largest investors,” he says.

Headline management fees on private equity funds are widely scrutinised and GPs, even the most in-demand ones, will not deviate far from “industry standard”. Perhaps co-investment – where there is no industry standard as yet – is an area where the most sought-after GPs can flex a little muscle in the fund terms tug-of-war.

LPs should probably start comparing notes.