Emerging managers offer co-investment rights to attract LPs

Limited partners these days love co-investing, and GPs are responding to that desire –especially emerging managers.

The most popular term that emerging managers offer limited partners is co-investment rights, according to fresh research from sister title Buyouts Insider and fund administrator Gen II Fund Services, LLC.

The survey found that 70 percent of respondents offered contractual co-investment rights to LPs. LPs use co-investing to gain direct exposure to deals, while still leaving the burden of managing the investments to their GPs.

Co-investments also give LPs a closer view into how a GP works an investment. They are seen overall as an unofficial “fee break” – an equity stake in a company that comes without fees or carried interest.

For emerging managers, co-investment rights can be a powerful incentive to attract investors to a fund. With enough co-investing interest, an early manager can conceivably raise a smaller fund but still stretch to do larger deals in preparation for raising larger funds in the future.

A common complaint from managers is that while every LP says it wants co-investment rights when a deal is offered, many can’t make a decision. It’s important for an emerging manager to understand its LP base and whether it truly makes sense to offer everyone co-investment, or identify those groups who are likely to participate.

The second most popular term, which 46 percent of respondents offer to their LPs, is discounted management fees based on commitment size. A close third, at 43 percent, is giving an investor participation in the limited partner advisory committee.

Less popular terms include allowing investment in the GP or management company (26 percent) and opt-outs on certain investments (15 percent).

Emerging managers, especially first-time funds, need to strike a balance between collecting enough fees to keep the lights on, but offering interesting terms to investors who may need a little nudge to invest in an early fund.

Investors who back early funds usually agree that young firms need to collect enough fees, so they don’t put too much pressure on such teams to offer management fee breaks. But these investors usually want something in exchange for taking the risk of backing a young firm.

The survey found that, out of 72 respondents, 74 percent did not feel pressure from their investors on fees. In terms of fee levels, 38 respondents said they charge a management fee in the range of 2.1 to 2.5 percent. Ten respondents said they charge in the range of 1 to 1.5 percent.

Raising early funds is not easy, even as institutional investors show interest in backing early funds as a way to get in at the beginning of what could become the next big private equity superstar.

Some young teams anticipating a long fundraising slog before they even get to start investing and showing off their skills choose to enter even tighter relationships with certain investors.

Around 44 percent of respondents reported having an anchor investor with more favorable terms, the survey found.

For those with anchor investor arrangements, 53 percent of respondents said they offered discounted management fees; 42 percent said they offered discounted carry; 39 percent offered co-investment rights; 33 percent offered an ownership stake in the GP; and 11 percent offered discounted fees or carry in subsequent funds.

Firms have cropped up in recent years focused only on buying stakes in the management companies of spin-outs or first-time funds. Such groups also generally require some form of revenue sharing, ownership stake, co-investment rights or other economic terms in exchange for various levels of support.

It’s not the path every emerging manager needs to take, so new managers should explore carefully the options available and what makes sense for them. The life of an emerging manager is not an easy one, but it can be rewarding for those who are able to translate their vision into reality.