There is a new normal in private equity markets. Limited Partner co-investing has grown past the point of a trend to an established method for LPs to actively invest.
LP allocations into co-investments have grown every year since 2012. In 2016, the total value of LP transactions was $103 billion by early December, which is more than any year since 2007. And this increase isn’t secluded to huge funds; we are seeing it in the middle market as well.
So, what’s driving this trend?
First, General Partners Increasingly Want the Capital That Co-Investors Bring
The thirst for capital is illustrated by a recent survey by ValueWalk, which showed that 87 percent of fund managers are offering co-investment opportunities.
A common reason PE firms do this is to take advantage of attractive investment opportunities that are outside the scope of their traditional fund. Because traditional PE funds are rigorously structured, it is difficult to jump on a new opportunity or make decisions on a short timeline. Co-investing allows both GPs and LPs to get around those restrictions.
In the middle market, co-investments are also often offered when transactions fail to close due to a lack of capital provided by an investor. By bringing in more capital from a co-investor, the GP is able to complete the transaction.
Second, Co-Investing Is Very Attractive to LPs
It used to be that co-investments were primarily used when private equity firms wanted to take on a particularly risky investment and having a pool of independent investors participating outside of the normal fund was a good way to disperse the risk. While that still happens, it’s not the norm anymore. Several factors have made co-investments much more attractive to LPs.
1. Co-investors are seeing better fund performance.
The most significant factor causing the persistent increase in co-investments is the number of LPs who are seeing great performance from their investments. According to Valuewalk, a surprising 80 percent of LPs report better performance than what they see in traditional PE funds.
2. The relationship between GPs and LPs has changed.
As the performance and attractiveness of the private market has gotten better year-after-year, the number of new GPs entering the market has increased. Even though LPs have been increasing the amount of capital they are infusing into the co-investment market, they are still undershooting their target allocations. Therefore, competition among GPs for LP funds has increased.
This has led to a particularly beneficial negotiating position for LPs. Co-investors are often able to eliminate the 2-and-20 fee structure that was almost always used in the past and is still used for traditional PE funds. In fact, 49 percent of GPs didn’t charge any management fees for co-investments. Also, LPs can have more influence in the operations of their co-investments than possible in a normal fund through partnership agreements.
3. Private markets are becoming more attractive than public markets.
The public markets are on an impressive nine-year rise. While the economy remains strong, it’s not irrational to be wary of a bull market that runs for this long. Consequently, some LPs are relying more heavily on private markets to leverage any potential correction in the public markets they think might be on the horizon. Co-investing is often the way many LPs choose to do this.
Expertise is Required
While co-investing is on the rise, that doesn’t mean that it has become easier to do for the average private market investor.
The two primary methods for co-investing are direct and side-car. A direct co-investment is when an LP invests in a pre-established opportunity offered by a GP. This makes the LP a stakeholder in the fund who can take a very active role its operations. A side-car is when the co-investment itself is set up as an LLC or LP, so the GP remains in control of the fund. The LP can negotiate things like entry and exit rights prior to making the investment, but it gives full operational discretion to the GP.
Successfully making a direct co-investment requires a lot of expertise in managing a private investment portfolio. Successfully making a side-car co-investment requires a very good relationship with the GP you’ll be working with.