Co-investment growth leads to uncertainty over terms

Co-investments have become standard in private equity, but arrangements between LPs and GPs don’t all fit the same mould.

In an environment where limited partners are trying to maximise returns and lower their fees, co-investments have become an ordinary component of the private equity landscape and of relationships between LPs and general partners.

Nearly two-thirds of LPs plan to invest in co-investment opportunities, according to the Private Equity International LP Perspectives Survey 2019.

“In the last five years, co-investments went from being pretty common to ubiquitous,” says Brian Gallagher, a partner and co-founder at Twin Bridge Capital Partners, which often co-invests alongside its GPs. “It’s gone from a topic at most fundraising meetings, to a topic at every fundraising meeting.”

But no two co-investment situations are the same and specific arrangements between managers and co-investors in the same deal often vary greatly.

Initially, GPs offer co-investment opportunities to their LPs in different ways.

“I’m seeing some sponsors forming specific co-invest funds ahead of time, anticipating that they’re going to need additional capital for specific investments that their main fund will make,” says Babak Nikravesh, a partner with Hogan Lovells and the co-head of the firm’s sovereign investor practice.

“But most people actually do it on an à la carte basis. They realise they need more money for a particular investment, maybe because they’re up against their percentage cap on how much they can invest per company and they have to go out and raise money from other institutional investors. Typically they will reach out to the people in their main fund, often preferred LPs who they hope will re-up in another fund and which they believe can provide capital promptly. Or they may reach out to other potential partners outside their main fund.”

Co-investments also differ in terms of the structure GPs adopt once they are about to make a specific investment.

The majority of general partners offering co-investments structure these transactions as a separate entity as opposed to direct investments in a portfolio company.

Gallagher believes it’s always better to be in the same vehicle as the sponsor of the deal, but adds that “as long as we have the right protection and rights, it’s form over substance”.

John Guinee, managing partner and co-founder of Constitution Capital Partners, also a frequent co-investor, thinks the type of structure varies depending on the size of the GP and that the creation of a limited partnership with co-investors is typically indicative of a bigger group of co-investors and often of a larger GP.

“The sponsor needs to create a mechanism so it doesn’t have to deal with each co-investor at a time,” he says. “The bigger the sponsor is, the less they want to deal with co-investors anymore.”

Co-investment arrangements also differ based on the types of fees and expenses being charged. One of the main drivers behind institutional investors wanting more co-investments is the ability to avoid paying management fees and carried interest on such deals.

The fee structure depends on how close the links are between the LP and the GP.

“If it’s a true co-investment that you’re offering to LPs in an existing fund, a no fee, no carry arrangement is pretty typical, but there’s a lot of variation,” says Nikravesh.

Gallagher notes that overall, whether a co-investor pays management fee and carried interest depends on if it is also an LP in the main fund. As co-investment transactions become larger, if interest among LPs from the main fund is not sufficient, GPs tend to reach out to investors who have not invested in the main vehicle.

“If you are not an LP in the fund, I think it’s totally reasonable to be charged a management fee and carry,” he says, adding that Twin Bridge only co-invests with existing managers.

Guinee agrees co-investments for existing LPs should be no fee/no carry. “Organisational and set up fee is all we ever see and that’s the only one we pay,” says Guinee. “All the other fees – management fees and carried interest, that’s more indicative of bigger funds,” he adds.

With so much money flowing into private equity funds and such a great interest among LPs for co-investments, the negotiating power has tended to swing into the hands of fund managers recently as opposed to co-investors.

“For savvier GPs, they’re recognising that co-invests are a hot commodity, and they may have the ability to command some alternative fee arrangement involving some form of management fee and/or carry depending upon the deal and LPs in question,” says Nikravesh.

This is especially true for strong performing money managers. But for first-time funds or managers starting a co-investment programme, co-investors can still have the upper hand.

It remains to be seen whether a downturn in the economy will modify co-investment appetite among LPs and as a result will impact LPs’ and GPs’ negotiating power.