The co-investment conundrum

Co-investments have become standard in private equity, but arrangements between LPs and GPs vary.

In an environment where limited partners are trying to maximize returns and lower their fees, co-investments have become an ordinary component of the private equity landscape and of relationships between limited partners and general partners.

Nearly 87 percent of fund managers offer co-investments to their LPs, according to pfm’s Fees and Expenses Benchmarking Survey.

“In the last five years, co-investments went from being pretty common to ubiquitous,” says Brian Gallagher, a partner and co-founder at Twin Bridge Capital Partners, which often co-invests alongside its GPs. “It’s gone from a topic at most fundraising meetings, to a topic at every fundraising meeting.”

But no two co-investment situations are the same and specific arrangements between managers and co-investors in the same deal often vary greatly.

Initially, GPs offer co-investment opportunities to their LPs in different ways.

“I’m seeing some sponsors forming specific co-invest funds ahead of time, anticipating that they’re going to need additional capital for specific investments that their main fund will make,” says Babak Nikravesh, a partner with Hogan Lovells and the co-head of the firm’s sovereign investor practice.

“But most people actually do it on an à la carte basis. They realize they need more money for a particular investment, maybe because they’re up against their percentage cap on how much they can invest per company and they have to go out and raise money from other institutional investors. Typically they will reach out to the people in their main fund, often preferred LPs who they hope will re-up in another fund and which they believe can provide capital promptly. Or they may reach out to other potential partners outside their main fund.”

Co-investments also differ in terms of the structure GPs adopt once they are about to make a specific investment.

While the majority of general partners offering co-investments structure these transactions as a separate entity as opposed to direct investments in a portfolio company, this is a small majority. Only 55 percent of respondents say they do so 100 percent of the time, down from 59 percent when pfm last surveyed fund managers in 2016. Meanwhile, 17 percent of respondents say they do so less than 50 percent of the time, down from 25 percent two years ago.

Gallagher believes it’s always better to be in the same vehicle as the sponsor of the deal, but adds that “as long as we have the right protection and rights, it’s form over substance”.

John Guinee, managing partner and co-founder of Constitution Capital Partners, also a frequent co-investor, thinks the type of structure varies depending on the size of the GP and that the creation of a limited partnership with co-investors is typically indicative of a bigger group of co-investors and often of a larger GP.

“The sponsor needs to create a mechanism so it doesn’t have to deal with each co-investor at a time,” he says. “The bigger the sponsor is, the less they want to deal with co-investors anymore.”

Co-investment arrangements also differ based on the types of fees and expenses being charged. One of the main drivers behind institutional investors wanting more co-investments is the ability to avoid paying management fees and carried interest on such deals.

According to the survey, only 28 percent of co-investment vehicles pay a management fee equal to the fee paid by the fund, a reduction from the 2016 survey when the figure was 32 percent.

The fee structure depends on how close are the links between the LP and the GP.

“If it’s a true co-investment that you’re offering to LPs in an existing fund, a no fee, no carry arrangement is pretty typical, but there’s a lot of variation,” says Nikravesh.

Gallagher notes that overall, a co-investor pays a management fee and carried interest depend on whether it is also an LP in the main fund. As co-investment transactions become larger, if interest among LPs from the main fund is not sufficient, GPs tend to reach out to investors who have not invested in the main vehicle.

“If you are not an LP in the fund, I think it’s totally reasonable to be charged a management fee and carry,” he says, adding that Twin Bridge only co-invests with existing managers.

Guinee agrees that co-investments for existing LPs should be no fee/no carry.

“Organizational and set up fee is all we ever see and that’s the only one we pay,” says Guinee, echoing the survey, which shows that more than 65 percent of respondents charge LPs organizational and set-up costs, up from 48 percent in the survey two years ago.

“All the other fees – management fees and carried interest, that’s more indicative of bigger funds,” he adds.

With so much money flowing into private equity funds and such a great interest among LPs for co-investments, the negotiating power has tended to swing into the hands of fund managers recently as opposed to co-investors.

“For savvier GPs, they’re recognizing that co-invests are a hot commodity, and they may have the ability to command some alternative fee arrangement involving some form of management fee and/or carry depending upon the deal and LPs in question,” says Nikravesh.

This is especially true for strong performing money managers. But for first-time funds or managers starting a co-investment program, co-investors can still have the upper hand.

It remains to be seen whether a downturn in the economy will modify co-investment appetite among LPs and as a result will impact LPs’ and GPs’ negotiating power.

Who pays when the deal breaks?

Broken deal expenses have become a more contentious topic between LPs and GPs

“We have felt some pressure in recent years and we’ve got a little bit more push back on these broken deal fees,” says Guinee. “But in our case it’s strictly if the deal doesn’t work for us as a group of co-investors, then we have to pay a penalty.”

Asked whether co-investors have any responsibility for broken deal expenses if a deal doesn’t go forward, 40 percent of respondents said that they do if the co-investment entity has been formed, up from 31 percent two years ago. At the same time, another 40 percent said they never do because the broken deal expense is purely a fund expense, up from 32 percent two years ago.

Meanwhile, less than 14 percent said they do because it is part of co-investors’ indication of interest in co-investing, down from nearly 27 percent two years ago.

“Who bears broken deal expenses is an important issue, and one which sponsors like to address up front,” says Nikravesh. “If co-investors will not agree to absorb broken deal expenses, the concern is that those expenses become a fund expense that the fund will have to absorb — and if that’s the case, you have to make sure that’s disclosed to the investors in the main fund.”