Anecdotal evidence from investors with whom Private Equity International has spoken points to an increasing number of co-investment-type transactions by “fundless” or “independent” sponsors – sponsors that have not raised a fund, but instead raise equity and debt financing on a deal-by-deal basis. These transactions often have terms much like those of a traditional co-investment and charge investors a tiered carry structure.

The volume of such deals will only increase over time, notes Charles Aponso, a London-based principal at global mid-market firm Quilvest Capital Partners. “The drivers are two-fold,” he says. “There’s going to be a bigger supply of deals coming from the GPs as they essentially look to raise more funds in innovative and non-traditional ways, especially in a more challenged fundraising environment.

“On the demand side – the LP side – we’ve seen a shift towards more co-investments over the past decades, and this is unlikely to slow down.”

According to PEI’s LP Perspectives 2023 study, 64 percent of LPs plan to participate in co-investment opportunities over the next 12 months – a figure largely unchanged from the previous year.

Co-investments are attractive to LPs for various reasons: a more appealing fee model, the ability to be more deeply involved in the assets, diversification, and the potential for higher risk-adjusted returns. For co-investment-type transactions by independent sponsors, the flexibility afforded to both parties is a huge draw.

Seeking flexibility

Claire Madden, managing partner at UK-focused investment firm Connection Capital, says the firm has seen in recent months a wide variety of co-investment opportunities with independent sponsors. Some of these managers have done transactions and seeded them with their own capital, she notes. “That only goes so far. You tend to find that they want to release some of the capital from those transactions. We quite like that because there are no deal execution risks, as the deal has already happened.”

“We’re seeing a lot of sponsors that have taken the view that, in the current marketplace, flexibility is more important”

Claire Madden
Connection Capital

Madden says that very often in such circumstances, the manager offers the co-investment after they’ve bedded down the investment for six months or so. What’s more, they are generally not asking for a premium and are happy to sell down the equity at cost.

She adds: “We’d rather have the flexibility to just take every opportunity on its own merits rather than sitting solely in a buyout fund – it means we can look at a wide variety of transactions with different risk/reward profiles. We’re seeing a lot of sponsors that have taken the view that, in the current marketplace, flexibility is more important rather than being constrained by a set of fund parameters.”

Hanspeter Bader – founding partner of Yana Investment Partners, which teams up with independent sponsors on deals in Europe’s small-cap space – notes that such transactions are a better way for LPs and GPs to work together.

He says that in such deals, between two and five parties work together with the lead sponsor to make the transaction happen. “We’re often working on a deal from the very early days. They approach us and say: ‘We’ve got a deal here in principle. Would you like to be part of that?’ And then we structure and work on due diligence together. It’s a much more proactive way of working together than in traditional co-investing.” He adds that in shaky environments, the blind pool fund model may be less attractive for investors who want deep insight into what they’re buying.

Key criteria

In both traditional co-investing and co-investments with independent sponsors, the alignment of interest is essential for LPs and GPs alike. Industry participants also note that the diligence and underwriting approach from an LP perspective does not differ greatly between the two types.

For Quilvest’s Aponso, getting comfort on: a) the quality and alignment of the investment team, and b) the deal sweet spot is key for fundless sponsor co-investments in particular, in addition to the typical co-investment underwriting criteria.

“The usual underwriting criteria… includes asking questions like: what are the team dynamics?” Aponso explains. “How aligned are they with their LPs? How differentiated are they? What is their value creation playbook? What is the quality and consistency of their track record? Do they buy and sell well, etc? And then, secondly [and] more importantly: does this particular deal fall under their sweet spot, from – for example – sector, geography, size, strategy, value creation levers [points] of view?”

He adds: “There’s not necessarily a correlation between performance and whether it’s a fundless sponsor or a sponsor with a fund, but there is definitely a correlation for underperformance when a co-investment does not fit these two criteria.”

“LPs might… be a bit more cautious about allocating capital and pivot to their existing GPs for co-investments”

Charles Aponso
Quilvest Capital Partners

Transparency is also important in co-investments, says Madden: “There is a fine balance between not wanting to run the investment yourself and just letting the manager get on with it. As we also lead our own private equity deals, we understand that sponsors want supportive but ultimately passive co-investment partners. However, if things go horribly wrong, having that enhanced capability and transparency gives us and our investors comfort that we can step in and help.”

This year, rising acquisition finance costs, uncertainty in pricing and slower deal volumes are expected to trickle down to the overall M&A market, including co-investments and the deal-by-deal space, industry participants note.

“As there is an element of uncertainty around the current investment environment… I think these sponsors are also going to be impacted, just like most other segments in PE. LPs might also be a bit more cautious about allocating capital and could pivot to their existing GPs for co-investments, at least in the short term,” Aponso says.

Bader also notes that the secondaries players’ refreshed appetite for LP stakes sales might reduce the available capital for independent sponsors. “Secondaries funds were quite often seen in such independent sponsor deals because these direct deals boost the multiple in their funds. Secondaries players, however, are very busy now with LP stakes because investors are selling at a 20-30 percent discount again.”