Co-investing offers risk and fee advantages for those interested in direct investing

They may not be right for every individual or family office, so it is important to take stock of one’s resources (mainly time, money and staffing) before diving into a deal

Daina Lawrence  •  Financial Post
Published May 17, 2022  •  3 minute read
An illustration of a coin cut in quarters with six people surrounding it, some holding coins. Co-investments can allow investors to gain more targeted exposure to attractive private equity transactions.
Co-investments can allow investors to gain more targeted exposure to attractive private equity transactions. GETTY IMAGES

For high-net-worth investors such as family offices looking for direct investing opportunities without shouldering all the risk, co-investing may offer a happy medium.

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Co-investing refers to a specific investing transaction made by a limited partner of a private equity firm alongside, not through, the firm. For instance, a private equity firm may approach members of its fund with investment opportunities that allow those members to acquire a percentage of an investment deal the firm is also investing in.

“The basic co-investment happens when a private equity fund gives the family office the ability to invest on the side,” explains Steve Balaban, chief investment officer at Mink Capital.

For instance, a private equity fund may find an investment that needs $30 million in equity. Normally that equity would come out of the fund, but in a co-investing deal, the fund can put in $20 million and then offer that the co-investor put in $10 million as a direct investment, making them a partner on the deal.

Research and due diligence done by private equity fund

This often means a lot of the research and due diligence is done by those at the private equity fund, so the resources required for the investor is often much less than it would be in a direct investment deal.

“And they often don’t pay fees on that,” he adds. “There actually is something that’s called deal origination fee, and it’s not always charged.”

Ash Jaidev, alternatives specialist for BlackRock in Canada, says deals like this can also mitigate the “J curve” impact that occurs in private equity and private market strategies – private equity investments often post negative returns for the first few years and go up in later years as the investment matures – since these deals allow capital “to be put to work almost immediately.”

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“Co-investments are often a great way for investors to gain more targeted exposure to attractive transactions, aligned with their investment objectives,” says Jaidev. “Clearly the trend of co-investing is here to stay. The data [from Preqin, as of May 30, 2021] shows that a significant percentage of fund managers (over 80 per cent in 2020) offer co investments, suggesting that the market continues to respond to LP [limited partners] demand.”

And although co-investing deals are growing in popularity, they may not be right for every individual or family office, so it is important to take stock of one’s resources (mainly time, money and staffing) before diving into a deal.

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“When live transactions are being syndicated to co-investors, time pressure is an important factor – some LPs may not have the capacity to underwrite a co-investment transaction within the time available to them,” explains Jaidev.

“Closely related is the challenge of resourcing, both in terms of staff available to review co-investments, and also, in terms of expertise, to assess the specific opportunity in question. Without the resources and time, LPs risk spreading too thin and missing important but potentially relevant components of a transaction.”

But if the resources are accounted for and the due diligence is achievable then a co-investing deal could be the right choice.

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Side letters lay out terms of co-investing deal

How much one puts into a deal is usually laid out before a co-investing deal is even brought to fruition. This is done in a side letter, which is a legal contract outlining the details of a co-investing partnership.

“I think it’s fair to say that you’re going to have better outcomes if you engage legal counsel with the appropriate expertise,” explains Angela Austman, a partner at the Vancouver office of Lawson Lundell LLP. This is where one can negotiate things like a seat on the board or how much money or the percentage one wants to commit to the deal.

“Side letters are so common these days that if you’re not asking for one and you don’t know what to ask for, I think you’re probably leaving some benefits on the table. You’re losing out on an opportunity,” says Austman.