The US and UK are seeing a diminishing number of companies in the listed markets whilst the private equity (PE) markets are booming. For investors, that raises a number of issues, of which fees are an important one. Private equity fees are much higher than those of listed equity managers.
Co-investing with general partners (GPs) is seen by many limited partners (LPs) as the solution. The ability to choose attractive deals where a GP needs assistance in funding without paying any management fees or carried interest can enable a much higher allocation to PE without incurring a higher fee burden.
GPs can choose who they offer co-investment deals to, so it is very much a relationship-driven activity, rather than transactions driven by competitive bids by LPs.
Given the economics, it is not surprising that the largest PE investors have invested considerable resources in building up and maintaining co-investment teams. For the aspiring co-investors, there are some key requirements expected of them if they expect to build up significantly sized co-investment portfolios. It helps to have a large fund size, since giving attractive opportunities to potential investors in future funds is a key driver for GPs when they decide who it is worth calling about a deal.
But just as important is the necessity to be able to respond quickly when there are tight deadlines to meet to clinch a deal. Quick negative responses can be almost as valuable as a quick yes, because it enables GPs to understand how much risk they can take on a deal or perhaps decide to move quickly on to a better opportunity.
That does mean some large private equity investors such as the large US pension funds in particular, can be disadvantaged when it comes to co-investment as they lack the governance structures to enable rapid responses to opportunities shown to them. Instead, they must adopt the alternative approach of outsourcing co-investment to funds of funds and paying fees, albeit lower than for primary funds.
When it comes to venture capital, the nature of co-investment is very different from buyout firms where there is typically a single funding event when a company is acquired. By contrast, there are multiple funding events for early-stage companies, each one at a higher valuation and offering a new opportunity for co-investment with a venture capital (VC) investor.
As a result, co-investment with a VC can imply a long relationship and an ability to join target company fundings at the stages acceptable to an investor’s acceptable risk/return level, possibly over multiple funding rounds.
What are the limits to how large a co-investment portfolio LPs should aspire to? That may come down to the resources required and the pricing seen in the marketplace.
Having a well-resourced deal team able to respond rapidly enough to entice GP offerings is a challenge when there may be either a feast or a famine in dealflow. But with the market awash with liquidity-seeking deals, newcomers should avoid the temptations of no-fee or carry-on deals that may still be overpriced.
Jospeh Mariathasan, Contributing Editor