The co-investment controversy

Disagreement over broken-deal fees could spell the end for co-investment if the regulator intervenes

Co-investment has become a ubiquitous and powerful tool for GPs, in both the world of fundraising and investment – employed by 80 percent of respondents to Private Funds CFO Fees & Expenses Survey 2022.

“We are seeing more co-investment supply than ever before,” says Andrew Bernstein, head of private equity at Capital Dynamics. “This is partly due to slower fundraising processes caused by the residual effect of travel restrictions and a logjam in the market. Uncertainty around ultimate fund sizes leads to conservatism in the size of the check some LPs are willing to write mid-fundraise.”

Appetite from investors is also increasing. “More and more investors are looking to build out their own direct investment portfolio,” says Dan Rochkind, CFO of Lerer Hippeau. “It makes complete sense that LPs would want to invest alongside a top-tier VC fund partner that has already sourced a deal, done most of the due diligence and negotiations, and will likely have a key role in monitoring and supporting the company post-investment.”

“Many LPs that did not historically co-invest have grown tired of effectively subsidising those that do,” adds Bernstein. “They have now built out their own teams or partnered with specialists in an effort to blend down fees as well as deepen their relationships with GPs. LPs can use co-investment to see how the sausage is made in order to better inform their decisions on the primary side.”

Indeed, the idea that co-investment can be used to lure new investors into funds is something that has courted controversy.

“Co-investment is a route through which LPs get to know GPs and potentially make the decision to invest in future funds,” says Joshua Cherry-Seto, CFO of venture capital firm StartUp Health and until recently of Blue Wolf Capital. “That could mean a GP is incentivized to offer co-investment to those investors in order to support future fundraising. There are typically policies in place governing how co-investment is awarded but those policies, and the extent to which they are adhered to, are going to come under increasing scrutiny.”

Meanwhile, co-investment allocation is not the only area where there is a lack of consistency. Some firms charge a management fee and carry equal to that charged by the fund – although the survey reveals a steady decline in this practice over time. Others charge reduced fees and some no fees at all.

“Fees chargeable are very much opportunity dependent,” says Neda Vakilian, managing director of global relationships at Actis. “In infrastructure, co-investment is traditionally half fees and half carry. However, fees may well be charged for third-party investors who are not in the relevant fund. It is not inconceivable that deal introduction fees might also be charged. How high these fees are will very much depend on whether the GP is in a strong bargaining position.”

Bernstein agrees: “Fees are all over the map. Some GPs charge upfront fees, management fees and/or transaction fees for M&A. Others don’t charge fees at all. LPs should demand transparency. As long as fee expectations are disclosed upfront, co-investors have an opportunity to negotiate, and in the end, they can decide if the impact on returns is such that they want to walk away.”

Where the real controversy lies, however, is in the treatment of broken-deal expenses when it comes to transactions slated to include co-investment capital. A third of respondents charge broken-deal expenses exclusively to the fund. A further 16 percent also charge these expenses to the fund, with the rationale that they charge co-investment deals that do close a fee payable to the fund, which compensates for broken deals elsewhere.

“The issue of how dead deal fees are shared continues to be debated in the market,” says Cherry-Seto. “The fund typically bears the cost, but if a proportion of the capital earmarked for the deal was never going to come from the fund, should that expense not be shared? It is a timely and important topic and one that the SEC may well take issue with.”

Anne Anquillare, head of US fund services for CSC, adds: “The industry doesn’t seem to be reaching any consensus as to how fees and expenses should be dealt with in these situations. And when the industry is unable to reach a consensus on a sensitive topic, that is typically when the regulator intervenes.”

But SEC intervention could ultimately prove fatal for co-investment. “I hope the use of co-investment isn’t regulated out of the market because it is an important tool,” Anquillare says. “But it is a tool that must be used and communicated appropriately, if it is to continue to have a role in this industry.”