Side by side

Could co-investing be the last frontier of LP returns enhancement? Andrew Sealy, a managing partner at London-based advisory firm Campbell Lutyens says LPs believe this to be the case

Although the current tidal wave of capital in the fundraising market has much to do with the impressive returns generated by large private equity funds, most market observers expect to see returns for similar investment vehicles compress going forward. The lower expected returns become, the more anxious are LPs about the spread between gross IRR and net IRR, which is caused by the many forms of fees taken by the GP (see ?Fee fandango,? p. 21). One way that investors have sought to partially avoid fee friction is through the secondaries market, where assets can be purchased several years into a fund's life, after several years of management fees have already been paid by the seller. But the increasing efficiency of the secondaries market has made this approach less effective.

Now limited partners are, more than ever, focused on the opportunity to co-invest equity alongside the main fund in deals. Especially the larger institutional investors view this as a smart way to get capital out the door because the checks are larger and the fees are smaller (or, at least, a little bit smaller). Traditionally, GPs have from time to time allowed LPs to co-invest in deals on a reduced-fee basis, or sometimes without paying any fees or carry at

?A GP can get a 25 percent gross return to investors, but that can net down to 16 or 17 percent,? says Sealey. ?There's a great attraction to LPs if they can get their hands on the same assets without paying the same fees. If you invest €100 million in a fund and then €100 million in a co-investment, you can effectively halve the erosion between gross and net, which can increase your return by 4 percent, which in a low-return environment is very significant.?

Limited partners are keenly aware of this math and are pursuing co-investment opportunities with increasing fervor. ?There is very strong interest in co-investing by the very large pension funds,? says a US general partner currently on the road with a large fund. ?They tell us, ?We'll commit $300 million or $400 million to your fund, but by God, you've got to show us some very attractive co-investment opportunities.?

Louis Singer, a partner in the New York office of Morgan, Lewis & Bockius who represents limited partner clients, says many LPs are ?jockeying for position for co-investment opportunities? because such opportunities are viewed as being potentially very advantageous. But, adds Singer, not every co-investment structure is created equally, and he is advising clients to carefully weigh the merits of the various vehicles being offered today by GPs.

Deals vs. funds
The most common form of co-investment vehicle historically has been created on a deal-by-deal basis when GPs have seen a need or ability to bring additional LP capital into a deal alongside the equity from the main fund. In these cases, terms are usually negotiated for each vehicle, and they have ranged from no fees to full fees.

Limited partners tend to like these deal-by-deal coinvestment structures, says Michael Lawson, a lawyer at London-based law firm Clifford Chance, because they have the opportunity to scrutinize each deal made available. That said, the process of contacting all the LPs in a fund about a co-investment opportunity and herding them into a co-investment partnership can be laborious, especially the first time around. But Lawson notes that with time the deal-by-deal process becomes more efficient. ?I've done first-time co-investments in under a month, and then the next time it's taken less than a week,? he says of the time needed to reach a co-investment fund closing.

Just as not every GP who claims to ?add operating value? can truly do so, not every LP who wants co-investment opportunities has the infrastructure to efficiently do so. ?The number of those LPs that actually have the execution ability to complete co-investments in an effective and timely manner is only a small subsector of those who imagine they would like to do them,? says Sealey. ?When you say, ?Look, you need to do your due diligence and tax structuring in a couple of weeks,? the reality dawns and it all seems rather more challenging.?

Some large LPs are in the process of adding staff specifically to respond to co-investment opportunities, while others are seeking outside help. This presents an opportunity for a growing list of advisors who offer assistance in co-investing. Some asset managers, like New York-based Lexington Partners, have created dedicated co-investment vehicles that pool LP capital for investment alongside GPs, where such opportunities are available. A different approach can be found in London-based advisory firm Glen Alta Capital, which provides resources to LPs who are actively pursuing co-investment opportunities on their own. Most large gatekeepers also provide similar services for a fee.

However, a second form of co-investment vehicle is gaining momentum in the market, one that Morgan Lewis' Singer describes as ?a different kettle of fish entirely? from the deal-by-deal approach.

General partners, including Bain Capital and The Blackstone Group (see box above) have sought to capture LP interest in co-investing by creating captive funds that invest alongside the main private equity partnerships in certain situations. The names casually applied to these funds are telling – they are called variously ?spillover? and ?overage? funds. Stockholm-based Altor Equity Partners recently closed a €1.15 billion fund that included a mandatory ?top-up? fund that will co-invest LP capital directly in portfolio company development.

GPs that raise these co-investment funds are taking advantage of the huge demand among LPs to put capital to work, especially at slightly lower fee levels. They are also responding to the larger deal opportunities that are coming their way. Given the chance to stretch on larger-thanaverage deals, many GPs would far prefer to draw on the capital of their own LP base than on equity from rival private equity firms, aka club deals.

In raising their own – often mandatory – co-investment vehicles, these GPs are also capturing economics that previously were ?given away? to LPs or were captured by funds of funds and other consultants. ?There is a lot of money out there, and GPs want to tie it up while the getting is good,? notes a lawyer, who notes that in his experience, LPs are ?accepting? of the latest breed of GP-controlled co-investment vehicles, if not thrilled.

Still, where there is a clear formula for putting LP capital to work in co-investments, LPs are responding with great demand. The GP currently on the road with a fund notes that his firm has no formal program for co-investing, and therefore he is cautious about making promises to hopeful LPs. ?You don't want to ramp them up and get them all excited,? says the GP. ?For the LPs who make a very clear expression of interest [in co-investing], we say, ?Duly noted. We will certainly keep you in mind.? We don't commit much more than that.?

Bain's way, Blackstone's way
Among the more sought-after private equity firms are New York-based The Blackstone Group and Boston-based Bain Capital, both of which are putting the finishing touches on new funds of roughly $13 billion and $8 billion, respectively. Both are also raising co-investment vehicles alongside the main funds, but the two structures are different.

Bain Capital has long managed separate co-investment vehicles, which allow limited partners to invest equity directly alongside the main partnership, and the new Fund IX also has an affiliated co-investment vehicle of $2 billion. Bain's co-investment vehicles give limited partners a break on fees, although the firm is so popular that the terms are still rather GP-friendly. There is no management fee charged on committed capital in the Bain co-investment fund, but there is a 20 percent carry (Bain's main fund charges an above-market 30 percent carry).

The formula for how the co-investment fund interacts with the main fund is clearly defined – any deal that requires more than $350 million in equity splits each additional dollar of required equity equally between the main fund and the co-investment fund. For example, a deal that requires $400 million in equity would take $375 million from the main fund and $25 million from the coinvestment fund. There is no obligation on Bain's part to do any deals over the $350 million equity level.

Typically Bain's larger limited partners commit to the co-investment fund. A source at Bain Capital says of the co-investment vehicle: ?It's a way for us to do bigger deals without having the management fee clock ticking [on the main fund]. We'd just as soon not feel the pressure to invest that money.?

Blackstone is also raising a co-investment vehicle, but it requires all LPs committed to the main fund to also invest on a pro-rata basis in the side vehicle. The Blackstone co-investment fund also does not charge management fees on committed capital, but it does charge full carry.