Private Equity Co-investments

Many private equity, real estate, and infrastructure fund sponsors offer co-investment opportunities to limited partners in their funds. The practice of offering co-investment opportunities to limited partners has been an accepted part of the industry since well before I joined it in 2008.1 The appetite for co-investments among limited partners—particularly certain large and sophisticated institutional investors with the resources to build in-house direct investment expertise—has grown significantly since the 2008 global financial crisis. Indeed, some large institutional investors have go so far as to begin building in-house private equity investment teams that independently invest in transactions.2 Medium-sized and large-sized family offices, too, are beginning to “rediscover” their heritage as investors in private equity investments and have become increasingly willing to make private equity co-investments or direct investments.

I find the rise of co-investments and direct investments by large institutional investors interesting for a number of reasons. Should the trend towards large institutional investors in-sourcing their direct private equity, real estate, and infrastructure investments continue, this will have significant impact on the ability of fund sponsors to secure capital commitments from these investors. Coupled with the trend of large institutional investors consolidating their fund commitments with a smaller number of fund sponsors, this could reduce the number of fund sponsors as capital commitments dry up and fund sponsors are unable to raise successor funds. It could also increase the trend towards specialization among fund sponsors, as large institutional investors will be unlikely to in-source expertise in every conceivable geography, industry, or value creation strategy. (There will always be large multi-strategy and multi-asset fund sponsors that will succeed on the strength of their brand and their ability to provide a “one stop shop” for investors that do not have the resources and time to build relationships with specialist fund sponsors globally or the skill to make direct investments, but such sponsors will by necessity be limited to a select few.)

Why Co-investments?

This question can be addressed from two perspectives, that of the fund sponsor and that of the institutional investor. For a co-investment relationship to work, both fund sponsor and institutional investor must feel that they gain a benefit from the relationship.

First, I will look at the reasons why a fund sponsor may elect to offer co-investments to its limited partners or other private equity firms. (Bear in mind that the following reasons are not mutually exclusive or collectively exhaustive.)

Need for additional capital to make the investment: Recall that most private equity, real estate, and infrastructure funds will have concentration limitations that prohibit the fund from investing more than a stipulated amount of the fund’s capital in a single investment.3 If a fund wishes to make an investment that would be larger than its concentration limits would permit, it can either seek approval from its advisory committee for this exceptionally large investment, or it can seek co-investors for the excess. Advisory commitees will often be reluctant to approve investments that greatly increase the fund’s concentration risk, and thus the only realistic option for the fund sponsor may be to seek co-investors.
Fill gaps in the capital structure of an investment: Where access to debt financing is constrained or available only on prohibitive terms, a fund sponsor may instead elect to offer part of an investment to co-investors.
Goodwill with investors: A fund sponsor may seek to secure a prospective investor’s commitment to its fund by offering co-investment opportunities, typically on a no fee and no carry basis, to that prospective investor. This can allow a fund sponsor to build or retain a relationship with an investor that is willing to re-up when the fund sponsor begins raising a successor fund. One example of this, from my experience with Partners Group in Asia, was where a first-time real estate fund sponsor in Asia—which shall remain unnamed for confidentiality reasons—was willing to offer co-investment opportunities to large, credible institutional investors willing to commit a minimum amount to its first close. The co-investment opportunities were a method of encouraging such investors to commit to its first close and generate much needed momentum and credibility for subsequent closes.
Strategic value-add for the portfolio company: A fund sponsor may offer a co-investment opportunity to a strategic investor in the same industry as the portfolio company to tap into the strategic investor’s industry expertise and contacts. A strategic investor that co-invests in a portfolio company may also be a potential buyer for the fund’s stake in the portfolio company at some point in the future. The fund sponsor may also offer the co-investment opportunity to an institutional investor with an extensive network in a region or industry where the portfolio company has expansion plans to tap that investor’s network of contacts and regional expertise.
Avoiding the potential conflict among fund sponsors associated with a club deal: In a club deal where an investment is acquired by multiple fund sponsors working in concert, there is a real risk that the fund sponsors will come into conflict over post-investment operational improvements, bolt-on acquisitions, or exit opportunities. As a general rule, co-investors are less likely to come into conflict with a fund sponsor over such matters, particularly where the co-investors are limited partners in the fund sponsor’s fund, as they have already approved the general investment and value-add approach of the fund sponsor. In my experience with co-investments at Partners Group, the level of involvement of a co-investor can range from active, regular involvement in decision-making at the portfolio company through a seat on the board of directors, to a hands-off approach with all decision-making handled by the fund sponsor that led the investment.
Relationship building with other fund sponsors: A fund sponsor may offer a co-investment opportunity to another fund sponsor if the second fund sponsor has special skill or expertise in the industry or region. As an example, drawing again from my experience, an Indian private equity fund sponsor invited another global private equity fund sponsor to co-invest in the operator of a chain of private schools in India due to the global fund sponsor’s prior investments in the education sector and its potential to introduce the portfolio company to contacts in the education sector in Europe.

The Institutional Investor

There are a number of reasons why institutional investors elect to pursue co-investments or direct investments. (Bear in mind that the following reasons are not mutually exclusive or collectively exhaustive.)

Exposure to deal-making and acquisition of direct investing skills: The institutional investor may wish to develop its ability to make direct investments in the future, and view co-investments with extensive and deep involvement in the acquisition process and post-acquisition operational improvements as a method of gaining much needed experience prior to building out its own direct investment practice. This approach has been taken by fund-of-funds managers, sovereign wealth funds, and large pension plans. Indeed, one can say that Partners Group began as a fund-of-funds manager in the 1990s, added co-investments, and eventually migrated to direct investing as a sole investor or lead investor in the late 2000s. This was certainly my experience at Partners Group from 2008 to 2014, when the direct investing practice was in its early growth phase.
Accelerated deployment of capital compared to fund investments: An institutional investor that invests in a private equity, real estate or infrastructure fund commits capital to the fund at the time it signs its subscription agreement. The fund sponsor will then call capital on an as needed basis to fund investments in portfolio companies. Depending on the investment pace of the fund sponsor, it can take several years for the majority of the capital to be deployed in investments or reserved for follow-on investments.4 By contrast, capital committed to co-investments is fully deployed at closing or within a relatively short period of time after closing. This allows the institutional investor to control the pace of their capital deployment.
Improve returns: A co-investment by an institutional investor that is a limited partner in a fund sponsor’s fund is frequently made on a no fee no carry basis. Ceteris paribus, an investment accessed through a co-investment will deliver higher returns (net of fees) than the same investment accessed through a fund charging the usual 2% management fee and 20% carried interest. Even where management fees and carry are charged (typically on co-investment funds managed by a fund sponsor), the amount charged will often be significantly lower: often in the range of 1% management fee and 10% carried interest. Moreover, the investment opportunities offered for co-investment are typically at least of decent quality given their importance as a relationship building tool for fund sponsors.

Lessons Learned from Six Years of Co-investing

At Partners Group, I worked on more than fifteen co-investments in Europe and Asia from 2008 to 2014, spanning the private equity, real estate, and infrastructure asset classes. Indeed, in the last two years that I was at Partners Group, the firm had begun to build up its capacity to offer co-investment opportunities to limited partners and investment mandate clients. From time to time, the firm would offer co-investment opportunities in some of the direct investments it was making. As such, I have been on both sides of the table: working on the investment team of a co-investor investing in investment opportunities sourced by other fund sponsors and working on the investment team of a fund sponsor offering co-investment opportunities to its investors.

I should state here that the skillset and processes required to make successful co-investments is subtly different from the skillset required to make successful direct investments or fund investments. While I do not expect that a blog post, or even a series of blog posts, can fully impart those skills, the lessons I have learned from six years of co-investing (and from having been involved in both legal and commercial aspects of co-investments) may prove edifying for those who are beginning to explore this investment strategy.

(Note that while I may make references to some deals that I have done in this post, for confidentiality reasons I will not provide any specific details that could identify the parties involved or the deal.)

Access to Co-investment Opportunities

How does an institutional investor get access to co-investment opportunities with a fund sponsor? The negotiations for access to co-investments will often begin at the time the institutional investor decides to make a capital commitment to the fund sponsor’s fund, i.e. during the fundraising process. The fund sponsor will often have made a determination—in consultation with its legal counsel—on whether to offer co-investment opportunities at all and if it decides to do so, how to document it; whether in the limited partnership agreement of the fund and side letters issued by the fund to certain investors, or in the form of an oral agreement to offer suitable co-investment opportunities to certain investors to avoid the need to disclose the offer of co-investment opportunities to other investors.

In my experience, the trend among fund sponsors to is to explicitly document in the limited partnership agreement of the fund their discretion to offer co-investment opportunities to limited partners of the fund and third parties, such as the following example from a pan-Asia buyout fund:

To the extent to which part of an investment opportunity remains available following determination of the amounts to be invested by the Partnership in an Investment in accordance with this Agreement then the General Partner may offer (but is under no obligation to do so) all or part of such investment opportunity to Limited Partners, the members of the board of directors and employees of Portfolio Companies, and such other persons as the General Partner may in its discretion decide.

The level of detail in the co-investment provision of a limited partnership agreement can vary from fund to fund. The example I’ve quoted is fairly light on details. I have seen examples that specified the order in which co-investment opportunities must be offered to different categories of co-investors, and specifying the general terms on which such co-investments must be made, and the general terms on which the fund and the co-investors must disposed of such co-investments.

Limited partners that have an appetite for co-investments will discuss their desire for co-investments with the fund sponsor as part of the negotiations that occur before they make a capital commitment to the fund, i.e. long before they expect to see any co-investments. If a fund sponsor agrees to acknowledge the limited partner’s interest in co-investments and agrees to offer co-investment opportunities to that limited partner, their agreement will generally be memorialized in a side letter, which may well be subject to a most favored nations clause. (The right to access co-investment opportunities should, in my view, be carved out from the most favored nations clause, because limited partners are not all equally capable of accessing co-investment opportunities, and if access to such opportunities was important to a limited partner, it should have negotiated for that right rather than rely on the most favored nations clause to “piggy-back” on the negotiation skills of other limited partners.)

In my experience, negotiating for co-investment rights can be thought of as a multivariate function with the following, non-exhaustive, variables:

The size of the limited partner’s capital commitment and the likelihood that the limited partner will commit capital to the fund sponsor’s successor funds, i.e. the financial value of the relationship to the fund sponsor
The capital available on short notice to the limited partner for making co-investments, i.e. the reliability of the limited partner as a funding source
The skill of the limited partner’s investment professionals and the speed of the limited partner’s investment decision-making process, i.e. the ability of the limited partner to evaluate an investment and decide whether to invest within the frequently tight timelines of a co-investment opportunity
The strategic, operational, and geographical value-add of the limited partner, i.e. the value that the limited partner brings to a portfolio company
The reputation of the limited partner, i.e. whether the fund sponsor and portfolio company would be comfortable being associated with the limited partner in press releases and news articles

Often, these negotiations also reflect the personal relationships and trust that exists between the limited partner and the fund sponsor, since there is an element of discretion on the part of both the fund sponsor and the limited partner: the fund sponsor can decide if it wishes to offer part of an investment as a co-investment, and which limited partners or third parties to offer it to; the limited partner has the option—but not the obligation—to invest in any co-investment opportunity the fund sponsor shows it.

The majority of these variables will be given, in the sense of being factors that you, as an investment professional, will have little ability to influence in the short-term. The one variable that you can affect in the short-term is the relationship and trust between your organization and the fund sponsor. It is, as has been often said in other contexts, a “people business”.

Different Levels of Involvement in Co-investment

Co-investors may have varying levels of involvement in a co-investment, ranging from completely passive providers of capital to actively partnering with the fund sponsor to drive operational improvements in the portfolio company. The level of involvement from the co-investors in the investment will often determine the appropriate structure and terms for the co-investment.

A co-investment structure is often a bespoke structure tailored for this specific deal and these co-investors and no other. Yet, if one has seen enough co-investments, one begins to see common themes around which bespoke terms and structures are constructed.

A co-investment structure tailored for an investment by co-investors that prefer to be passive providers of capital is different from a structure tailored for an active partner. The former is likely to invest indirectly, through a special purpose co-investment vehicle—often a limited partnership or limited liability company—controlled by the fund sponsor and have limited (or even no) control over the portfolio company. The latter is likely to invest directly in the portfolio company or a holding company incorporated by the fund sponsor to hold the investment and will negotiate for minority protections and representation on the board of directors of the portfolio company or holding company.

Determining where on this spectrum a co-investor wishes to be is a strategic decision that should be taken by the co-investor’s management team in advance of any co-investments and may differ across asset classes and regions. It’s important for the co-investor to have a clear understanding of its strengths and weaknesses in each asset class and region; taking a role in the co-investment process that it is not ready to play can be damaging to the co-investor’s reputation among fund sponsors and portfolio companies. The appropriate level of involvement in the co-investment can also be conditioned on the relative sizes of the investment by the co-investors and the sponsor in the co-investment, i.e. if a co-investor is committing a substantial fraction of the total amount needed for the co-investment, it should be entitled to a greater level of involvement in the decision-making of the co-investment.

It is also important to have clarity on what level of involvement the co-investor will have in the co-investment before definitive documentation is prepared by legal counsel to the sponsor of the co-investment. Lawyers are expensive and having to “do over” the entire deal documentation will be an unnecessary and avoidable expense. Moreover, making significant changes to the co-investment structure while also negotiating the terms of the investment with the sellers of the portfolio company can be extremely challenging and should be avoided if at all possible.

Failure to establish the parameters of the co-investment at the onset can result in significant difficulties for the co-investors and the sponsor. In an East Asian real estate co-investment that I was involved in, there was a significant difference of expectations among the investment team, the investment committee, and the sponsor of the co-investment (a pan-Asian real estate fund sponsor with limited co-investment experience). The investment team expected the investment to be slanted towards a less active participation in the day-to-day management and operational improvements of the property, i.e. skewed slightly more towards the passive end of the co-investment spectrum. My firm’s investment committee expected a significantly more active participation in the management of the property, i.e. skewed towards the active end of the co-investment spectrum. The sponsor of the co-investment expected, based on the discussions it had had with the investment team, an extremely passive co-investor that would invest through a special purpose vehicle controlled by the sponsor. The deal structure and its associated documentation were tailored for the sponsor’s expectations, which did not match the expectations of the investment committee and did not quite match what the investment team had expected and communicated to the investment committee. While the investment closed on time, there were a lot of unnecessary costs, a lot of time wasted, and a lot of goodwill lost.

It was, to be blunt, a Charlie-Foxtrot, and one that taught all involved three lessons, which I hope others will learn from:

The investment committee or investment decision-makers of the co-investor must have a clear vision of what kind of involvement can reasonably be expected from their investment teams, and communicate their expectations to the investment teams tasked with sourcing and evaluating co-investment opportunities in advance.
The investment teams of the co-investor must understand the level of involvement they are expected to have in the co-investments they source, and communicate this clearly to the sponsor of the co-investment in advance, so that they can discuss their mutual expectations for the co-investment and come to an agreement on the broad outlines of the co-investment deal structure before either party expends significant effort on structuring and negotiating the co-investment.
The sponsor of the co-investment should make its own assessment of the level of involvement in the decision-making of the investment it is willing to offer to co-investors, and discuss that with the co-investors before beginning to structure the co-investment.

Information, Non-compete, Non-solicit, and Exclusivity

The sponsor, if it expects to invite co-investors to participate in the investment, must ensure that their confidentiality agreements with the portfolio company permits them to share information with their sources of financing, which should explicitly include potential co-investors. In my experience, negotiating this with some portfolio companies or sellers can be quite difficult because their preference is to limit the number of persons that might access such information.

Some portfolio companies or sellers may also want to apply non-solicit and non-compete clauses to co-investors, which the fund sponsor should reject.5

A co-investor and their counsel should pay attention to the terms of the confidentiality agreement that the sponsor has signed with the portfolio company or seller. The confidentiality agreement may be a “back-to-back confidentiality agreement”,6 where the terms of the confidentiality agreement with the co-investor mirror the terms of the confidentiality agreement between the sponsor and the portfolio company or seller.

The co-investor, if it has an active co-investment practice, should be cautious about agreeing to any form of exclusivity with the sponsor at the stage of signing a confidentiality agreement, particularly if a portfolio company has received bids from more than one sponsor. A co-investor may, if it is not careful, find itself bound to an exclusive relationship with one of the losing bidders and be subsequently unable to negotiate for a co-investor position with the winning bidder. This happened to my firm in one of its potential co-investments in a highly regulated industry in Asia a few years ago, where the investment team came to an initial opinion that it would be unlikely to invest with any other sponsor due to the specialized knowledge needed to succeed in that industry and country. When the first sponsor failed to secure the deal, a second investment team in my firm came to a different conclusion and decided that it would like to work with a second sponsor, only to find that it had bound itself to exclusivity with the first (losing) sponsor.

Due Diligence for Prospective Co-investors

The due diligence process for a co-investment will differ from that which might be expected for a direct investment or for a fund investment; indeed, one can say that it is a midway point between the two. Compared to due diligence on a direct investment that the co-investor is making, it will necessarily be less comprehensive. Compared to due diligence on a fund investment, it will necessarily include a substantial analysis of the due diligence done by the sponsor on the portfolio company.

The first step of due diligence for prospective co-investors is to read—thoroughly—all the materials prepared for the sponsor by its advisers. Where there are issues raised in the materials that have not been resolved, ask the sponsor for their rationale for not resolving the issue. Speak to the investment team at the sponsor. Understand the thought processes behind their decisions.

The second step is to determine, based on the evaluation of the sponsor, whether the co-investor should supplement the sponsor’s work with their own independent evaluations, including engaging professional advisers of their own to review the work done.

In my experience, while relying on the sponsor’s diligence is often a reasonable option if the sponsor is an experienced investor in the industry and geography of the portfolio company, there are times when it can fail. In an emerging market like one of the BRIC countries, one can never be too cautious when evaluating the due diligence materials prepared by the sponsor. Indeed, in some cases it can pay to do independent due diligence on a portfolio company and its management. This was the case for one of Partners Group’s least successful Asian co-investments, which was done as a co-investment in a company in one of the BRIC countries with a large global private equity investor as the sponsor, where the commercial due diligence was less thorough than it should have been, and where the portfolio company had engaged in deceptive practices relating to its financial accounts.

The guiding mantra for a co-investor when conducting due diligence on a co-investment should be, in the immortal words of Ronald Reagan, “Trust, but verify.” A co-investor must have some trust in the competence and honesty of the sponsor, otherwise there is no point in participating. But a co-investor should still verify that the due diligence is thorough and identifies the legal, commercial, and financial issues that might increase the risk of the investment.

Conclusion

Co-investments can be an attractive method of investing in private equity, real estate or infrastructure. Indeed, in a world where the costs of investing in such funds is a constant while outsized risk-adjusted returns are not, controlling some portion of the cost of investing in private equity, real estate or infrastructure assets through co-investments is a prudent choice for institutional investors. I expect that some combination of co-investments and direct investments will become a significant component in the portfolios of most large institutional investors.

Co-investments are, however, a distinct form of investing from direct investments or fund investments, and institutional investors should bear that in mind when selecting people for their co-investment teams. The lessons I have learned were hard-won, and I doubt that I have seen all the different permutations of problems and challenges that can emerge from a co-investment program.