Co-investment is the long standing but regularly overlooked subset of Private Equity (PE) which has helped fuel the sector's record setting activity over the last two years. With co-investment as a contributor to PE funding growth, 2014 saw 2,700 buyouts globally worth US$386bn, the highest value since 2007. Even though 2015 cooled slightly, it was still on pace to be the second best year since 2008. In response to this resurgence of co-investments, Mergermarket, an M&A intelligence and news service, conducted a market-wide survey (Survey) of 50 US based private equity executives who had co-invested within the last 3 years. The results provide an interesting look 'behind the curtain' of the newly favoured investment mechanism.
What is a co-investment?
Simply put, co-investment is when a fund (sometimes referred to as a general partner or sponsor) partners with an individual investor (sometimes referred to as a limited partner or co-investor) to invest in a separate company. For example, Fund A, which is composed of investors 1-4, wants to buy Company B. However, Fund A does not have enough capital available to purchase Company B. Fund A then decides to offer to co-invest with one of their investors, Investor 4. This is a standard co-investment; however, they can be more complicated with multiple individual investors, and investors who are unrelated to the fund.
Co-investment climate
Co-investment is an increasingly popular option for PE firms looking to gain access to additional capital without long term commitments. According to the Survey, 56% of funds actively offer co-investment opportunities to their limited partners (LPs). Moreover, an additional 42% offer co-investment if the opportunity presents itself. However, despite these high numbers co-investment only occurs in 30-40% of deals.
Interestingly, co-investment is highly centralized. 62% of LP investors are already investors in the co-investing fund, as well an additional 18% are referrals from the LP investors, meaning that only 20% of co-investors are unrelated to the fund or its underlying LPs. While this does reduce risks as the co-investors will likely be more comfortable with each other, it also shows a missed opportunity for funds to branch out and increase their client base.
The structure of the co-investment varies by the needs and desires of the parties. There are five main structures the LP takes:
- an indirect investment in the portfolio company;
- a direct investment in the portfolio company;
- an indirect investment through a special purpose vehicle controlled by the sponsor;
- an indirect investment in holding company; and
- a direct investment in holding company.
The most popular structure is an indirect investment, where the investor does not take a role in the company and is simply there to reap the rewards of a separate investment. Interestingly, the Survey also suggests LP investors are increasingly pushing for direct roles and even requesting board seats for their investments.
Opportunities and challenges
Co-investment provides benefits to both parties. LPs get a bigger stake in the investment with very little 'legwork', while PE firms get to share the risk of the investment, extract more capital from investors and facilitate relationships with specific investors outside of the constraints of the fund. The main stumbling block to co-investment is regulatory scrutiny; in fact it was the largest and most often cited concern in the Survey. Regulators are increasingly turning their eye to these transactions and looking for increased transparency in co-investments, particularly when it comes to fees and expenses.
The resurgence of co-investment has fueled a welcome boost to the PE market which provides a benefit to investors and organizations alike. It will be interesting to see how the market for co-investments will continue to evolve as more sophisticated investors take part and push for more active roles.
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