Private equity co-investment transactions have steadily gained popularity with both private equity investors and private equity fund sponsors in the past few years, and we expect this trend to continue and accelerate in 2015.
In a private equity co-investment transaction, an investor invests in an M&A transaction alongside the sponsor’s primary fund. Investors are drawn to co-investment as it gives them the opportunity to build out their private equity exposure—often on terms that include reduced management fees and sponsor carry—and the option to select the co-investments in which to participate. This freedom of selection is viewed as an advantage over, or a complementary strategy to, passive blind-pool fund investments.
Sponsors equally view co-investment transactions as beneficial in the right circumstances. Co-investments provide sponsors with access to additional capital to complete larger investments that would otherwise require equity capital in excess of a sponsor’s investment concentration limit under the fund’s governing documentation, or in excess of the exposure the sponsor feels is appropriate for the fund. Co-investments also have the potential to deepen sponsors’ relationships with their limited partners.
Why Are Co-Investments Gaining in Popularity?
The rising popularity of private equity co-investment transactions has been driven by the following factors, each of which we expect will continue:
Increased investor expertise
Leading-edge institutional investors have been developing in-house deal capabilities for many years. Their successes have inspired many other investors to emulate this model, and a natural first step in developing in-house expertise is to seek out and execute co-investment transactions.
Investor demands for co-investments
Many large private equity investors have become selective in their fund allocations, preferring to develop concentrated relationships with a limited number of sponsors. These investors will often only devote commitments to funds offering meaningful co-investment opportunities to the investor, frequently on a priority basis to other potential co-investors. The increasing prevalence of these arrangements, which are often formally set out in the investors’ side letters, naturally leads to an increase in co-investment transaction volumes.
Enhanced net returns
Private equity investors continue to seek ways to increase the net returns on their private equity portfolios. Since co-investors often pay reduced (or no) management fees and carry entitlements on capital deployed in co-investment transactions, those savings can help investors enhance their net returns, which contributes to further investor demand for co-investment opportunities.
Given the current seller’s market, more and more sponsors are looking to partner with others in order to share the risks of any given investment. Club deals (where a sponsor seeks to partner with other private equity sponsors to complete an M&A transaction) have become less common in part as a result of the highly competitive deal environment and the decreased number of mega-buyouts since the credit crisis. Sponsors are turning instead to “friendly” parties (the sponsor’s own limited partners) as deal partners for M&A transactions.
Investor relationship benefits
The fundraising environment for many remains challenging. Sponsors are keen to differentiate their funds from others, and a history of successfully offering co-investment opportunities to investors is a tangible benefit many investors find attractive.
Sponsors have offered co-investment opportunities to investors considering making capital commitments to their funds—the co-investment opportunity is used to build the relationship between the parties and as an inducement to make the future capital commitment.
Co-investment transactions, however, are not for everyone and sponsors do exercise judgment on when and to whom a co-investment opportunity is offered. An ideal co-investor is often an institution with deep experience in M&A transactions and strong internal resources (so that the co-investor can quickly make decisions and meet funding and other deal timelines). Any relevant industry expertise and networks that could enhance the investment returns are also valuable.
To the extent that a co-investor expects to play an active role in the co-investment (through board seats, veto rights or otherwise), a common view on key deal drivers, as well as a strong working relationship between the sponsor and the co-investor, will be vital. Issues can and do arise down the road, however, including differing investment time horizons, and the resulting friction can be damaging to the sponsor-investor relationship.
We see great opportunities for co-investments to continue to both shape dealmaking in 2015 and drive growth in the private equity asset class.
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