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Co-Investment Craze Continues to Heat Up in PE Market

18 March 2014

Demand for co-investments is climbing, with 40 percent of investors actively pursuing opportunities to plunk down cash alongside private equity funds, highlighting the method's significance as limited partners hunt for higher potential returns and fund managers look to overcome a challenging fundraising environment, experts say.

A recent study published by alternative asset investment data analyst Preqin shows that on top of those actively co-investing, another 37 percent of those surveyed are doing so on an opportunistic basis, and 16 percent are hoping to co-invest in the near future.

Experts believe several factors have been driving the increased interest in co-investments. For limited partners, the tool offers an opportunity to invest more directly in a portfolio company with fewer fees, which, although riskier, can drive stronger returns.

"On the investor side, it's something investors thought could be a great way to get more direct access to great deals, more access to the economics," said Alison Bomberg, a partner with Ropes & Gray LLP.

Meanwhile, investors have been trimming down the number of funds to which they contribute, making private equity fund sponsors work harder to lock down capital in an already challenging fundraising environment. So for sponsors, bringing on co-investors can supplement funds, sew up larger deals with less debt and deepen relationships with limited partners.

"For the sponsors, it lets them work off of a smaller fund base and without competition. It essentially can be a bit like a consortium but with co-investors, who don't view themselves as competition," Bomberg said.

A Rare Perk No Longer

The notion of investing additional capital alongside a private equity fund is not new. But the practice seems to be growing in popularity as large limited partners like pension funds, insurance companies and financial institutions continue to consolidate their investments in search of greater efficiency, explained Jared Hershberg, a partner in Winston & Strawn LLP's New York private equity practice group.

According to Preqin, 75 percent of those who are taking advantage of co-investments said they were seeking the potential higher performance, while 70 percent cited lower costs.

And with the increased competition for the capital many limited partners are sitting on, general partners have been left scrambling.

"The fundraising environment has been very challenging for a lot of middle-market sponsors, even some with good track records," Hershberg said. "The end result is that there are a lot of GPs chasing after fewer investment dollars. The law of supply and demand applies here — there is high demand on the part of GPs and limited supply on the part of potential LPs."

So general partners have become more willing to grant investors special rights, like the right to co-invest, in an effort to meet fundraising goals or to supplement funds that fell short of expectations, experts say.

And the largest investors aren't the only ones reaping the benefit of these special rights, according to Preqin. The study found that 28 percent of investors with less than $250 million allocated to private equity have more than 10 percent of their private equity investments dedicated to co-investments — the same statistic that held true for investors with more than $5 billion in private equity.

"Co-investments are a much more significant part of the overall conversation in the fundraising process in today’s world," said Andrew Wright, a private investment fund partner with Kirkland & Ellis LLP in New York.

Co-Investment Challenges

Despite their growing attraction, co-investments can add a layer of complexity when it comes to pounding out a successful deal. Of the fund managers surveyed by Preqin, 58 percent believe that offering the option slows down the deal-making process. This is because bringing a limited partner into a transaction can require navigating extra regulations, such as limits on foreign investments, different tax treatments or potential antitrust issues, Bomberg explained.

"Depending on the co-investor group, they can make things more complicated," she said.

Roughly 33 percent of fund managers in the Preqin survey also noted that co-investments can hinder relationships with limited partners who do not have access to the opportunity. But managers can anticipate this issue and easily handle it in the early stages of the fundraising process, through partnership agreements and side letters that clearly lay out who is eligible to pursue co-investments and when, Wright explained.

"There is more focus on this, more discussions from all sides — and earlier in the process," he said. "There is no single approach, no universal market standard as to who, if anyone, should have a contractual right to these opportunities. Is it the existing investors? Do certain investors, like large investors, have a preferential right? Does the sponsor have to right to allocate those opportunities to whomever it sees fit?"

By fine-tuning its approach early on, the general partner will be more apt to avoid the complications co-investments can present, he said.

Win-Win

Even though the co-investment trend was created by challenges in the market, it is generally seen as a positive change for both sponsors and investors, explained Stephen Hertz, a Debevoise & Plimpton LLP partner.

Co-investment can serve as a way to buy a company with a price tag outside of a fund's parameters, supplement a fund that closed below target or market additional contributions to a fund during fundraising. And if the co-investor has experience in a specific sector, it can help make a buyout bid stand out, according to Hertz.

"If done right, it can be a win-win for all people involved," he said.

The benefit of bringing more capital to the table in a deal generally outweighs the challenges that co-investing can present, explained Hershberg, who believes the trend is here to stay.

"The precedent has been set in terms of the rights being granted to large limited partners. I believe that even if the fundraising environment becomes less challenging for sponsors going forward, it's going to be difficult for them to retreat from the granting of co-investment rights," he said. "The market has been established."

Andrew Wright, P.C.

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