Co-investing refers to limited partners (LPs) investing alongside general partners (GPs) in private equity deals. It has become an increasingly popular way for LPs to gain more control and potentially higher returns. There are two main forms of co-investing: direct co-investments, where LPs invest directly in companies alongside GPs; and fund-level co-investments, where LPs invest in specific deals through an investment vehicle managed by the GP. As co-investing gains traction, it is transforming LP-GP dynamics and the private equity landscape.
The main drivers spurring the rise of co-investing
There are several key factors driving the growth in co-investing:
1. Excess capital – LPs have record levels of dry powder accumulating, estimated at over $1 trillion in 2020, which motivates them to find ways to put this capital to work.
2. Desire for control and customization – Through co-investing, LPs gain more visibility and control over specific deals rather than investing blindly into funds. This customization ability is attractive.
3. Potential for higher returns – By reducing or eliminating fees and carry paid to GPs, LPs can boost net returns on successful deals, often targeting returns 5% or more higher from co-investments.
4. Relationships with GPs – Co-investing enables LPs to strengthen partnerships with top-tier GPs and gain preferential access to choice investment opportunities.
5. Diversification – For LPs concentrated to certain sectors or geographies, co-investing facilitates carving out customized exposures. It also helps mitigate J-curve and timing risks inherent in blind pool funds.
The main risks and challenges associated with co-investing
Despite the benefits, there are also notable risks and challenges to co-investing that LPs should be cognizant of:
1. Information asymmetry and adverse selection – LPs rely on GPs providing access to quality deals and transparency. However, GPs may cherry pick deals to co-invest in.
2. Intensive due diligence requirements – LPs take on added diligence responsibilities previously handled by GPs in traditional fund investments. And the accelerated pace of co-invest decisions strains resources.
3. Governance complexity – With multiple parties involved, governance and alignment of interests becomes more intricate in co-investments. Legal terms need to be institutionalized.
4. Portfolio construction challenges – The sporadic and irregular nature of co-investment deal flow makes portfolio planning and diversification difficult for LPs. Unpredictable exit timing also complicates matters.
5. Organizational constraints – Few LPs possess the operational capabilities and strategic focus required to successfully execute an aggressive co-investment program at scale.
The outlook for the evolution of the co-investing landscape
Looking ahead, co-investing is likely to become a more substantial allocation for LPs as it gains further momentum.
From the GP perspective, large LPs bringing co-investment capital to the table can help fund larger deals and expand GP investment capacity. It also forges stickier LP-GP relationships. As a result, GP fundraising could increasingly emphasize and prioritize co-investment rights.
For LPs, integrating co-investment capabilities by developing specialized teams and processes allows them to reap the potential benefits more methodically. As LPs strengthen, some may explore migrating to more direct and GP-like investing approaches.
Overall, co-investing represents an important shift in private equity dynamics, transferring more control and power to LPs. It also enables further disintermediation. However, for the ecosystem to function effectively, the interests of LPs and GPs need to remain well-aligned.
Co-investing alongside GPs provides LPs potential for higher returns and more control, but also entails heightened risks. LPs should approach it strategically and selectively