Private Equity Co-Investments

In the world of investments, private equity co-investments stand as a strategic alliance between investors and fund managers, offering a pathway to minority ownership in a company. This collaborative approach empowers investors to enter potentially lucrative ventures while sidestepping the hefty fees associated with traditional private equity funds. In this article, we unravel the intricacies of private equity co-investments, exploring their benefits, rationale, and the nuances that potential co-investors should be aware of. Join us on this journey to understand how co-investments are reshaping the investment landscape.

Demystifying Equity Co-Investments

Amplifying Returns: The Dynamics of Private Equity Co-Investments
Amplifying Returns: The Dynamics of Private Equity Co-Investments

In the realm of investments, an equity co-investment is a strategic maneuver wherein investors join forces with a private equity fund manager or a venture capital (VC) firm to make a minority investment in a company. This collaborative approach empowers investors to delve into potentially lucrative ventures without the weighty fees commonly associated with private equity funds.

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Unlocking the Benefits of Equity Co-Investments

  1. Strategic Symbiosis: Co-investments, though smaller in scale, run parallel to substantial investments by private equity or VC funds.
  2. Fee Liberation: Co-investors often enjoy reduced or even waived fees, gaining ownership stakes proportionate to their investment.
  3. Capital Amplification and Risk Mitigation: Larger funds stand to gain from increased capital and decreased risk, while individual investors benefit from diversifying their portfolios and establishing connections with seasoned private equity professionals.

Delving Deeper: Understanding Equity Co-Investments

Recent research by Preqin reveals that a staggering 80% of Limited Partners (LPs) reported superior performance from equity co-investments compared to conventional fund structures. In a typical co-investment scenario, the investor engages with a fund sponsor or general partner (GP) with whom they share a well-defined private equity partnership. This partnership outlines the allocation of capital and diversification of assets, effectively sidestepping the conventional limited partnership (LP) and general (GP) fund structures by directly investing in the target company.

The Surge in Co-Investments: A Paradigm Shift

Intriguingly, McKinsey’s consulting firm highlighted a remarkable surge in co-investment deals, soaring from $104 billion in 2012 to an astonishing $104 billion in 2018. The percentage of LPs participating in co-investments in Private Equity (PE) witnessed a substantial rise from 42% to 55% over the past five years. However, the growth in direct investing LPs was comparatively modest, increasing by a mere one percent from 30% to 31% during the same period.

Unraveling the Logic: Why Private Equity Managers Opt for Co-Investments

Why Private Equity Managers Opt for Co-Investments
Why Private Equity Managers Opt for Co-Investments – Amplifying Returns: The Dynamics of Private Equity Co-Investments

The rationale behind private equity fund managers offering co-investment opportunities lies in the intricacies of their investment portfolios. In some instances, the LP’s resources may already be fully allocated to various companies. This situation presents a choice: either forego a prime opportunity or extend the offer of an equity co-investment to select investors.

Targeting the Sweet Spot: LP Preferences

Axial, a leading equity raising platform, emphasizes that nearly 80% of LPs favor small to mid-market buyout strategies, with a sweet spot ranging from $2 to $10 million per co-investment. In essence, the focus shifts towards less ostentatious companies, specializing in niche areas rather than pursuing high-profile corporate investments. Surprisingly, almost half of the sponsors waived any management fee on co-investments in 2015.

The Renaissance of Equity Co-Investments

In the post-financial crisis era, equity co-investment has emerged as a substantial contributor to the growth of private equity fundraising, eclipsing traditional fund investments. According to consulting powerhouse PwC, LPs are increasingly gravitating towards co-investment opportunities when negotiating new fund agreements with advisers. This shift is driven by the promise of heightened deal selectivity and the potential for amplified returns. While most LPs shell out a 2% management fee and 20% carried interest to the fund manager (the GP), co-investors revel in lower or zero fees, bolstering their overall returns.

The GP’s Ace: Leveraging Co-Investments

At first glance, it may seem that General Partners (GPs) relinquish fee income and some degree of control by embracing co-investments. However, this strategic move allows GPs to circumvent capital exposure constraints and diversification mandates.

For instance, if a $500 million fund identifies three enterprises valued at $300 million each, and the partnership agreement limits fund investments to $100 million, the firms could leverage $200 million for each entity. In the event of an opportunity with an enterprise value of $350 million, the GP could secure external funding for the additional $250 million and extend co-investment opportunities to existing LPs or external parties.

Navigating the Nuances of Co-Investments

Amplifying Returns: The Dynamics of Private Equity Co-Investments
Amplifying Returns: The Dynamics of Private Equity Co-Investments

While co-investing in private equity endeavors offers a plethora of advantages, potential co-investors are well-advised to scrutinize the finer details before committing. Transparency concerning fees is of paramount importance, as private equity firms often provide scant information on the fees levied on LPs. In cases like co-investing, where purportedly no fees are involved in large deals, there may be hidden costs, such as substantial monitoring fees.

Furthermore, it’s crucial to acknowledge that PE firms might receive payments from companies in their portfolio to facilitate deals. This dynamic introduces an element of risk for co-investors, as they wield minimal influence over deal selection and structuring. Ultimately, the success or failure of such ventures hinges on the expertise of the private equity professionals at the helm, a factor that may not always align with optimal outcomes.

A vivid illustration of this dynamic unfolded with the Brazilian data center company, Aceco T1. In 2014, private equity titan KKR Co. acquired the company in conjunction with co-investors – Singaporean investment firm GIC and the Teacher Retirement System of Texas. However, it was subsequently revealed that the company had manipulated its financials since 2012. This prompted KKR to write down its investment in Aceco T1 to zero in 2017, underscoring the inherent risks associated with co-investments.

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Conclusion

In conclusion, the realm of equity co-investments is a nuanced landscape with immense potential for both investors and fund managers. By understanding the intricacies and weighing the advantages against the risks, stakeholders can navigate this terrain with confidence, potentially unlocking unprecedented returns.