What is an Equity Co-Investment?
An equity co-investment is a minority investment in a company made by investors alongside a private equity fund manager or venture capital (VC) firm. Equity co-investment enables other investors to participate in potentially highly profitable investments without paying the usual high fees charged by a private equity fund.
Equity co-investment opportunities are typically restricted to large institutional investors who already have an existing relationship with the private equity fund manager and are often not available to smaller or retail investors.
- Equity co-investments are relatively smaller investments made in a company concurrent with larger investments by a private equity or VC fund.
- Co-investors are typically charged a reduced fee, or no fee, for the investment and receive ownership privileges equal to the percentage of their investment.
- They offer benefits to the larger funds in the form of increased capital and reduced risk while investors benefit by diversifying their portfolio and establishing relationships with senior private equity professionals.
Understanding Equity Co-Investments
According to a study by Prequin, 80% of LPs reported better performance from equity co-investments compared to traditional fund structures. In a typical co-investment fund, the investor pays a fund sponsor or general partner (GP) with whom the investor has a well-defined private equity partnership. The partnership agreement outlines how the GP allocates capital and diversifies assets. Co-investments avoid typical limited partnership (LP) and general (GP) funds by investing directly in a company.
Why Limited Partners Want More Co-Investments
In 2018, consulting firm McKinsey stated that the value of co-investment deals has more than doubled to $104 billion since 2012. The number of LPs making co-investments in PE rose from 42 percent to 55 percent in the last five years. But direct investing LPs grew by only one percent from 30 percent to 31 percent during the same period.
Why would a private equity fund manager give away a lucrative opportunity? Private equity is usually invested through an LP vehicle in a portfolio of companies. In certain situations, the LP's funds may already be fully committed to a number of companies, which means that if another prime opportunity emerges, the private equity fund manager may either have to pass up the opportunity or offer it to some investors as an equity co-investment.
According to Axial, an equity raising platform, almost 80% of LPs prefer small to mid-market buyout strategies and $2 to $10 million per co-investment. In simple words, this means that they prefer to focus on less flashy companies with expertise in a niche area as opposed to chasing high-profile company investments. Almost 50% of sponsors did not charge any management fee on co-investments in 2015.
Equity co-investment has accounted for a significant amount of recent growth in private equity fundraising since the financial crisis compared to traditional fund investments. Consulting firm PwC states that LPs are increasingly seeking co-investment opportunities when negotiating new fund agreements with advisers because there is greater deal selectivity and greater potential for higher returns.
Most LPs pay a 2% management fee and 20% carried interest to the fund manager who is the GP while co-investors benefit from lower fees or no fees in some cases, which boosts their returns.
The Attraction of Co-Investments for General Partners
At first glance, it would seem that GPs lose on fee income and relinquish some control of the fund through co-investments. However, GPs can avoid capital exposure limitations or diversification requirements by offering a co-investment.
For example, a $500 million fund could select three enterprises valued at $300 million. The partnership agreement might limit fund investments to $100 million, which would mean the firms would be leveraged by $200 million for each company. If a new opportunity merged with an enterprise value at $350, the GP would need to seek funding outside its fund structure because it can only invest $100 million directly. The GP could borrow $100 million for financing and offer co-investment opportunities to existing LPs or outside parties.
The Nuances of Co-Investments
While co-investing in private equity deals has its advantages, co-investors in such deals should read the fine print before agreeing to them.
The most important aspect of such deals is the absence of fee transparency. Private equity firms do not offer much detail about the fees they charge LPs. In cases like co-investing, where they purportedly offer no-fee services to invest in large deals, there might be hidden costs. For example, they may charge monitoring fees, amounting to several million dollars, that may not be evident at first glance from LPs.
There is also the possibility that PE firms may receive payments from companies in their portfolio to promote the deals. Such deals are also risky for co-investors because they have no say in selecting or structuring the deal. Essentially, the success (or failure) of the deals rests on the acumen of private equity professionals that are in charge. In some cases, that may not always be optimal as the deal may sink.
One such example is the case of Brazilian data center company Aceco T1. Private equity firm KKR Co. acquired the company in 2014 along with co-investors, Singaporean investment firm GIC and the Teacher Retirement System of Texas. The company was found to have cooked its books since 2012 and KKR wrote down its investment in the company to zero in 2017.