Introduction

Private equity sponsors have typically offered co-investment opportunities to certain large investors in their main funds, or as a means to bridge financing gaps in deals they might not otherwise be able to consummate. In recent years, investor demand for co-investment opportunities has grown significantly as they seek to lower net costs, increase fund allocations and more closely manage their portfolios. In turn, sponsors have used co-investors to enhance deal-making capabilities, cultivate relationships with important investors and increase the number of deals in which they can invest. Many limited partners also see co-investments as a way to build institutional knowledge about the deal process by working with experienced sponsors with the goal of ultimately bringing some or all investment management functions in-house, thereby further reducing third-party investment manager costs. This article provides a high-level overview of co-investments, the benefits and detriments of co-investments for sponsors and investors and the current outlook for co-investing.

Co-Investments Generally

Fund investors negotiate soft and hard rights to be offered co-investment opportunities by sponsors. A soft right constitutes a mere acknowledgment by a sponsor of an investor’s interest in co-invest opportunities, whereas a hard right is a contractual requirement to provide an investor co-investment opportunities (such as the opportunity to take up its pro rata share of co-invest opportunities offered by the sponsor to other fund investors). Co-investment terms are typically much different than investment terms in a private equity fund, and we will discuss certain typical co-investment terms in a future article. There are, however, a number of benefits and detriments private equity sponsors should consider before offering soft or hard rights to co-investment opportunities, and that investors should consider before pursuing co-investments, certain of which are discussed below.

Benefits and Detriments of Co-Investments

Private equity sponsors benefit from offering co-investment opportunities by obtaining immediate access to additional capital in the event its main fund has insufficient funds to close a transaction, and co-investments are typically less costly and time consuming than looking for third-party investors. Private equity funds are also subject to concentration limits, and co-investments allow sponsors to utilize third-party capital to consummate larger transactions than may have been possible otherwise due to these restrictions. Offering co-invest opportunities also attracts investors to a sponsor’s primary fund and builds relationships and goodwill with investors, which facilitates future fundraising. Finally, co-investors are typically not viewed by sponsors as competitors and they may have expertise in certain geographies, industries or assets that can be helpful to sponsors in managing an investment and facilitating a successful exit.

There are also disadvantages to private equity sponsors offering co-investment opportunities, including having to cut or eliminate monitoring and other fees in order to entice co-investments, and ceding governance rights and control over material decisions (e.g., recapitalizations, acquisitions or timing of an exit) regarding an investment. Offering co-investment opportunities can also result in slower deployment of capital from a sponsor’s main fund, potentially jeopardizing performance for core fund investors, and cause delays in consummating transactions due to time and labor intensive offering and due diligence processes involving co-investors.

By contrast, investors can benefit from co-investments by retaining greater control over deployment of their capital than in a private equity fund. Because co-investments provide for direct investments in particular assets, investors can control the pace at which their capital is deployed and adjust their risk profiles by controlling their exposure to particular assets or industries, and investing in market conditions of their choosing. Additionally, because sponsors typically reduce or eliminate monitoring and other fees to attract co-investors, investors usually reap a higher rate of return through co-investments than an investment in the same asset through a private equity fund. Finally, asset managers (including pension funds and sovereign wealth funds) are becoming more interested in building out their own internal investment teams, and co-investments give them opportunities to gain insight into, and learn from, experienced sponsors’ processes for sourcing and selecting deals, conducting due diligence, negotiating and finalizing documentation and managing and exiting investments.

Pursuing co-investment opportunities can also pose novel risks to investors because they require investors to conduct due diligence quickly on a sponsor’s timeline, which may not allow investors to properly identify and forecast risks associated with an investment and lead to a lower rate of return or a sub-optimal portfolio of assets. In many cases, co-investors have access to the legal due diligence findings of the sponsor and rely on such due diligence by reviewing the summary memoranda prepared by the sponsor’s counsel and, if necessary, having focused discussions with the sponsor and its counsel on specific known issues. However, in larger co-investments, and in instances where there are issues to which a co-investor is particularly sensitive, we have seen co-investors conduct their own legal due diligence investigation – whether internally or by relying on their outside legal counsel and other advisors.

Additionally, co-investors need sufficient available capital necessary to complete co-investments on short notice, which restricts the amount of capital investors can set aside and deploy toward other investments.

Finally, direct co-investments increase headline risk with respect to each investment, versus a private equity fund in which risk is disbursed among a larger number of passive (and usually unknown) investors in the fund. In some instances, we have structured co-investments so as to avoid any public disclosure of the identity of the co-investor, but that may not be possible in transactions involving regulatory approvals, proxy solicitations or third party consents.

Given the lack of time to conduct due diligence that investors may have when considering co-investment opportunities, and increased risk with respect to each such investment, as compared to other investments, co-investors should carefully screen and consider with which sponsors it co-invests.

Current Outlook

The right to participate in co-investment opportunities has become an important right sought by investors investing in private equity funds. Because an increasing number of investors are expressing a desire to do deals on a direct basis (as opposed to through a private equity fund), sponsors not willing to offer co-investment opportunities risk losing large investors in their main funds to competitors that do offer such opportunities. Many institutional investors no longer invest with sponsors that do not offer co-investment opportunities, and we have even see some investors sell out of their holdings in funds that do not offer such opportunities. Additionally, many institutional investors face increasing pressure to reduce investment costs, which is why co-investment programs with reduced fees are increasingly being sought by investors. Building a fully functional internal investment team may seem to be the optimal outcome for investors from an efficiency, risk management and cost-management perspective, and the knowledge gained while investing alongside sponsors directly in assets will help investors build and run internal investment teams. However, we do not foresee many investors fully transitioning to internal investment management, given the cost, time and difficulty of assembling a skilled in-house investment team that will be able to run a successful direct investment program (a concern shared by many pension funds’ CEOs).

In light of the above, we fully expect the current co-investment surge to continue. Sponsors still prefer full control of their investments (which is offered by traditional private equity funds), but sponsors who do not offer co-investment rights risk losing deep-pocketed and coveted institutional investors. In an effort to keep these investors, most sponsors are willing to offer co-investment opportunities and accept the accompanying overall lower fees to ensure the availability of flexible and committed capital. As more investors take advantage of co-investment opportunities, we anticipate increased focus on allocation rights and negotiation of other specific co-investment terms by investors prior to investing in private equity funds.

Conclusion

Although sponsors prefer to have discretion in allocating investment opportunities and controlling the management and exit of investments, investors have continued to push, and we believe will continue to push, for co-investment opportunities. As discussed above, co-investment opportunities can be beneficial for both sponsors and investors in the private equity space, but co-investment opportunities should be approached thoughtfully by both sides.