Co-investing special: 10 crucial questions for investors

Co-investing has soared in popularity in recent years. But with managers increasingly charging fees and competition for direct deals growing, there are good reasons to be wary when evaluating opportunities. We consider the issues LPs need to weigh up when considering the risk of co-investments.

1. I am being offered a chance to co-invest on a deal. What will that entail and what will I have to do?
Co-investments come in many shapes and sizes, ranging from direct investments in portfolio companies to separate co-investment funds that invest alongside the main GP fund. The big advantage is the lower fees, but there are risks too: “Co-investing increases portfolio concentration. This can be a good thing if the investments perform well, but it does pose risk to the programme if the investments perform poorly,” says Brett Fisher, a managing director with Fisher Lynch Capital, who has overseen more than 75 private equity co-investments.

Designing a successful programme takes great care and attention: “Co-investing involves an entirely different method of investment analysis than fund investing,” says Fisher. That can mean taking on new staff with different skillsets.

Investment timelines also require quick decision-making: As one LP with extensive experience of co-investing says: “To do co-investments, you have to have a deep team, you have to be able to respond quickly, and you have to be willing to add risk to your portfolio, which co-investment does.”

2. Am I being shown the best deals or the worst?
One of the myths about co-investing is private equity firms only show their worst deals to co-investors, keeping the most attractive ones for themselves.

Indeed, there’s no way to find out exactly whether a general partner has specific criteria regarding which deals it shows to which investor and there usually isn’t any language in the fund documents on this. “GPs don’t have any obligation to show you every co-investment deal,” says Michael Saarinen, a counsel at Goodwin Procter’s private investment funds practice.

But the belief that co-investors get a raw deal runs counter to the experience of most LPs, according to Brian Gallagher, a managing partner at mid-market firm Twin Bridge Capital Partners. He cited several reasons.

“Equity sponsors do deals they think will perform well and will meet return hurdles,” he wrote in the second edition of PEI’s A Guide to Private Equity Fund of Fund Managers. “Second, and perhaps more importantly, equity sponsors value and need their LP relationships and therefore strive to ensure that co-investment LPs are satisfied with the sponsor’s performance.”

3. What if I think that I am getting a raw deal?
If an LP does have its suspicions, there are some ways investors can make sure they are not being shown the worst deals. Investors can ask a GP how many people have passed on an investment when presented with an opportunity.

They can also pre-empt such a situation all together by asking specifically to be shown all deals during fundraising. “If an investor wants to see all the deals, the LP can ask for a side letter,” Saarinen says. Another way to circumvent this is to commit to co-investment funds only, but LPs should be aware that in this case, they’ll typically have to participate pro rata in all the deals.

4. Are management fees justified?
One of the main incentives for limi-ted partners wanting to co-invest alongside their general partners initially centred on lowering the cost of private equity. Indeed, when these opportunities first appeared, LPs paid no management fee and no carried interest, effectively reducing the cost of investing.

But this is changing and fund managers are increasingly charging fees and carried interest when they can. More than 60 percent of US fund managers surveyed for the recent pfm Fees and Expenses Benchmarking Survey said they were charging management fees and/or carried interest on their co-investments (see p. 65 for more details). It makes sense as GPs shouldn’t be expected to work for free.

But how much LPs should pay remains a big question. “The market practice regarding co-investment terms is changing rapidly and there's no consistent approach on fees charged,” David Goldstein, a partner with DLA Piper, says.

The management fee can range from zero in the case of emerging managers to as much as 1.5 percent for established managers with a track record of making co-investments available to investors, he notes. Carried interest could range from nothing to 20 percent.

“Investors have traditionally pushed for a no-fee basis, but the largest managers are able to charge fees and it has become an important element in the relationship between these managers and their largest investors,” he says.

5. How can I get myself up the pecking order?
While a GP is under no obligation to show LPs all their opportunities, investors can boost their chances by routinely informing fund managers of their interest in co-investment to see “sufficient and attractive dealflow”, says Andrea Auerbach, head of global private investment research at Cambridge Associates, in a report entitled “Making Waves: The Cresting Co-Investment Opportunity”.

Daniel Lee, head of fundraising and investor relations at Dallas-based private equity firm Aethon Energy, agrees: “LPs who want the best dealflow should make sure they are in near constant communication with GPs they would like to co-invest with. Having GPs know their investment objectives, process, and capabilities will allow them to access the opportunities they are seeking,” he says.

6. How much due diligence should I be doing?

Many LPs take an active role in due diligence by hiring specialist teams to evaluate the investment opportunities, but that isn’t the only approach. The Massachusetts Pension Reserves Investment Management Board, one of the best performing private equity programmes in the US, prefers a more fast-track approach. When it set up its co-investment programme in 2015, it took a long hard look at its existing private equity managers and chose the ones with the best track records in co-investments.

When presented with an opportunity by these pre-qualified GPs, it typically will approve, provided it falls within some pre-approved parameters. “We don’t need any lengthy approval process,” says CIO Michael Trotsky.

“We’re not second-guessing their analysis and it’s a very quick turnaround. That’s a competitive advantage in

7. Am I expected to be an active participant in this deal or just to pay up and sit back?
There’s no obligation to be an active participant – as one US GP says: “We welcome but do not expect the involvement of our more passive LP fund co-investors.” But many LPs prefer to take a more hands-on approach to ensure they are aware of exactly what’s in their portfolio and are able to keep tabs on any potential risk issues.

A more active stance can also boost the relationship with the GP: “I think many of our managers appreciate the fact that we do our due diligence alongside them, and we expect to have numerous conversations with GPs. They appreciate that we are as engaged as we are,” says Scott Reed, US co-head of private equity at Aberdeen Asset Management.

8. Could my co-investment contravene SEC rules?
Although co-investments are becoming the norm, there is no set industry policy on how they are allocated. Because the decision ultimately lies with the manager, investors and regulators increasingly want to know that the process is fair. The SEC is particularly concerned that GPs are informing some LPs about co-investment opportunities before others.

In a statement in May 2015, Marc Wyatt, director of the SEC’s Office of Compliance, Inspections and Examinations, said that the SEC had “detected several instances where investors in a fund were not aware that another investor negotiated priority co-investment rights. Disclosing this information is important because co-investment opportunities have a very real and tangible economic value but also can be a source of various conflicts of interest.”

In particular, LPs need to be aware that although the SEC believes that co-investment allocations are the GP’s responsibility, there are situations that could put some LPs at risk of scrutiny. “It is generally the responsibility of the manager to offer and execute the co-investment in accordance with the law and their fiduciary duty,” Wyatt told PEI.

“One high risk area for LPs who are fund of funds managers, however, is a situation where a primary commitment and a co-investment are made out of different funds. In those situations, the LP should be careful not to make decisions that disadvantage one of its funds in order to benefit the other,” he says.

9. How will my co-investment deals stack up against my fund investments?
The multi-million dollar question, and one that sparks a passionate debate among GPs, LPs and academics. Guy Hands, the founder and chairman of Terra Firma Capital Partners, is a firm believer that co-investments don’t offer superior returns: “I don’t think directs give people any greater return than the savings on fees. Those fees are worth paying, that’s where I would be,” he told last year’s pfm Investor Relations and Communications Forum Europe.

Hands receives at least partial backing from academic research which has found that the gross performance of co-investments is at best similar to non co-investments, and may even be worse. The most damning evidence came in a 2014 study conducted by INSEAD’s Lily Fang and Harvard’s Victoria Ivashina and Josh Lerner which found that co-investments have historically underperformed the corresponding funds they invest with, mainly due to what they termed an “adverse selection” of transactions available to investors.

More recent research drawing on a larger sample of deals by Tim Jenkinson, professor of finance at the Private Equity Institute at Said Business School, University of Oxford, was a little more encouraging. The mean return of co-investments was actually “pretty similar” to the fund performance mean, Jenkinson told this year’s SuperReturn International conference.

10. What’s my liability if a deal fails to close?
One key area of interest for the SEC is how fees are allocated between funds and co-investors when a deal fails to complete. In June 2015, KKR had to pay $30 million after it was accused of misallocating more than $17 million in broken deal fees to its funds.

“Although KKR raised billions of dollars of deal capital from co-investors, it unfairly required the funds to shoulder the cost for nearly all of the expenses incurred to explore potential investment opportunities that were pursued but ultimately not completed,” said Andrew Ceresney, director of the SEC’s enforcement division, at the time.

KKR was criticised for not being explicit about the treatment of the expenses in its fund agreement or related offering materials. “The regulators are very conscious of expenses as an area of concern,” says Phyllis Schwartz, a partner at Schulte Roth and Zabel. “Given the regulatory issues, we are careful to ensure that all investors know who is getting the co-investment rights. We focus on describing the co-investment terms, such as whether the co-investors are paying expenses or not, particularly with respect to dead-deal expenses.”