Co‑investing in a retail age: allocation, economics and alignment

 
Retail funds are investment vehicles designed to provide certain non-institutional investors, who may not otherwise have access to private funds (e.g., accredited or high-net-worth individuals), with exposure to alternative strategies. While retail capital is not new to private markets, it has rapidly grown in scale in recent years, particularly through the proliferation of ’40 Act funds in the United States. That growth is reshaping the dynamics of a co-investment market that has historically been a predominantly institutional ecosystem.

Jockeying for allocation

The most prominent concern of institutional investors is that the influx of retail capital may impact co-invest allocation. Institutional investors typically rely on “fee-and-carry-free” co-investments as a way to reduce economics payable at the fund level, thereby enhancing their net returns. Accordingly, they have raised concerns around how sponsors plan to manage allocations between their institutional and retail clientele, including whether allocation to the retail fund will dilute the co-investment opportunities available for their institutional investor partners.

Regulation meets reality: who pays for what?

The fact that retail funds often carry higher management fees and charge performance fees based on the value of the portfolio, including unrealized assets (as opposed to institutional closed-end funds, which calculate carried interest based on actual cash distributions), exacerbates the concern that sponsors would prioritize the deployment of retail capital.

Relatedly, institutional investors have surfaced worries that sponsors could seek to introduce additional fees for institutional investors, as a growing retail base creates perceived “opportunities to monetize” co-investment deal flow.

In addition, some commentators have raised concerns that GPs may be motivated to structure their retail products in ways to exempt them from certain fees (such as warehousing and broken deal costs and expenses), especially given that retail investors already bear a higher fee load. This could lead to institutional investors being asked to disproportionately bear warehousing costs and broken deal fees. ILPA has warned institutional investors to protect themselves by diligencing that these types of fees will be properly shared with the retail funds co-investing with them and to try to discipline sponsors in this respect¹.

Similarly, institutional investors may want to ensure that the additional regulatory or compliance costs attributable to retail funds are not passed along to co-investors as ongoing partnership expenses.

Will retail capital quietly shape deal selection?

Given the liquidity requirements of retail funds, institutional investors have also raised concerns around portfolio construction, particularly when coupled with typically lower return expectations for retail products. With the increasing influx of retail capital, sponsors may gravitate toward co-investments that offer more stable cash flows, operate in sectors that have historically proven to be more resilient or provide greater exit optionality in order to align with the redemption requirements of retail funds. There is a concern that, over time, these dynamics could lead to strategy drift and result in lower returns than institutional investors have historically achieved.

Transparency

Where institutional co‑investors are accustomed to bespoke, ILPA‑informed reporting norms, retail frameworks may rely on different templates, cycles and disclosure regimes. A further risk for institutional LPs is a potential transparency gap (i.e., if sponsors were to try to leverage this dynamic and deliver diluted reporting to LPs).

Building a balanced tower

Arguably, some of these concerns may prove overstated. Sophisticated LPs bring many advantages to the co‑investment table that retail investors cannot readily match—swift, high‑conviction diligence; the ability to commit meaningful capital (sometimes across the cap table); and disciplined, efficient execution.

Sponsors, in turn, have strong incentives to serve the interests of their longstanding institutional partners with those of their expanding retail channels. In today’s market, sponsors will need to balance expanding pools of capital without letting any single constituency distort alignment.

Even so, when assessing co‑investment programs alongside sponsors that manage or plan to launch retail products, institutional investors would be well served to sharpen their diligence and ensure that the Jenga tower has a solid foundation. A focused review of allocation policies, economics, valuation practices and liquidity management can help ensure that the influx of retail capital enhances, rather than erodes, transparency and alignment. As emphasized in the ILPA White Paper², the aim is not to cast institutional and retail capital as adversaries, but to enable durable coexistence—anchored by consistent governance, fair treatment and clear disclosure.