Pulling together

Is a problem shared a problem halved? Mid-market private equity firms are increasingly teaming up with other investors to co-fund investments in attractive businesses.

“Co-investments are being driven by investors’ appetite for increased access to private markets and greater diversification, by PE firms’ desire to provide further opportunities for investors, and to drive momentum in a tricky fundraising market,” says Shervin Shameli, head of the funds practice at law firm Taylor Wessing. 

It is important to define some terms. For some investors, co-investing has traditionally meant buying assets alongside one or more partners, with each partner taking a stake – minority or majority – that has shareholder rights and responsibilities attached. In other words, the partners become co-owners of the business.

Such deals still happen, enabling investors to team up in order to do larger deals than their risk appetite would ordinarily allow, say, or to pool expertise and connections – perhaps in particular sectors or geographies. “If it makes sense for us and the deal fits our investment criteria, we are prepared to consider those opportunities,” says Alex Snodgrass, partner in the growth team at BGF, the investment fund set up a decade ago to address the funding gap in the scale-up market. “In some cases, we’ll work as equal partners, but we also take lead or junior partner roles.” 

New order

More commonly in private equity today, however, co-investment has come to mean something slightly different, particularly in the mid-market. A private equity firm, or general partner (GP), managing a fund will invest its assets in a portfolio of businesses on behalf of investors, or limited partners (LPs). It may then invite some or all of those LPs to invest directly in certain portfolio businesses, outside the fund structure. These are co-investments, but with the GP taking the lead in owning and managing them. Some firms may even offer these opportunities to investors that aren’t LPs in the fund. 

ECI Partners regularly offers co-investment – but with the LPs in its funds, rather than other GPs. Co-investing LPs will participate either through post-deal syndication or co-underwriting, and will typically invest in a sub-fund set up exclusively to take a stake in the new portfolio company, alongside the main fund’s investment.

Such arrangements are becoming increasingly common. Data from law firm Dechert suggests 54% of private equity firms in Europe now offer some form of co-investment programme, a rise on previous years – although still well down on the US, where 73% of firms offer co-investment opportunities. From the LP’s perspective, these opportunities have several advantages. Not least, GPs typically levy reduced fees or carry charges on co-investments, or no fees at all, enabling LPs to mitigate the traditional – and expensive – ‘two-and-20’ cost structures that private equity entails. The blended fee across the whole investment is much lower. “We offer co-investment on a fee-free, carry-free basis, which has obvious attractions for our LPs,” says Chris Mockford, ECI Investor Relations Director. “The benefits for ECI are that we can maintain appropriate diversification in the fund, by sharing a portion of some larger investments, and strengthen the relationship with our LPs.”

Co-investments also provide a more targeted approach, giving LPs access to the most attractive assets. They can pick and choose opportunities, rather than investing blindly through a fund structure. “I get to pick my shots rather than delegating decision-making to a fund manager,” says Peter Knight, head of co-investments at Connection Capital, one active player in the field. “There are opportunities to do our own diligence and to meet the management team at potential investee businesses.”

It’s a way into direct private equity investment for institutions such as pension funds, family offices and wealth managers that would not – or could not – raise their own GP funds.

“There was a time when some sponsors felt almost embarrassed about being fund-less,” says Knight. “There’s no longer any stigma attached to co-investing in this way – and the corporate finance advisory sector is on board, too; there’s been a real shift.”

Co-investments provide LPs with upfront exposure; by contrast it may take a private equity fund several years to fully deploy capital from investors. Indeed, visibility over liquidity – LPs know what capital they will be expected to commit and when – is a related plus-point.

Increasing trend

These benefits have prompted LPs to seek out more co-investment opportunities, says Guy Davies, managing partner of the mid-market private equity firm WestBridge. “We have LPs that certainly want to invest in our funds, but also have a strong appetite to invest alongside the fund,” he says. “They want the opportunity to co-invest at better economics, reducing their overall fee drag – and we have to be pragmatic about the dynamics of the market we operate in.”

Ashley Broomberg, managing partner at mid-market PE firm Mobeus Equity, agrees that demand from LPs has been increasing. “When we raise funds, we are now very often asked whether we will be offering co-investment opportunities to LPs; they see it as an attractive, low-cost way of securing direct investments,” he says. “Several investors in our funds have clauses in their side letters that formalise that interest and request that we show those opportunities to them.” 

Co-investments can have significant attractions for GPs, too. In a slower PE environment, where fundraising has been challenging, offering opportunities of this kind can encourage LPs into a fund – and help strengthen relationships with LPs both current and potential. 

Another benefit is the opportunity to build larger stakes in businesses that GPs are excited about. Most private equity funds set concentration risk limits – a single holding must not account for more than a certain percentage of total assets – but co-investments enable the GP to go further.

Indeed, says Mickey Patel, a partner at mid-market private equity investor August Equity, co-investments can also help firms move towards larger fund sizes more quickly, providing a track record of managing bigger sums and more significant individual deals. 

“In reality, what’s happening now is that when a PE firm sets out to raise a certain fund target, it is probably raising a quarter or a third more through additional co-investment commitments following the fund close,” he says. 

Davies also points out that co-investors often bring more than just capital. WestBridge has set up a co-investment vehicle through which a group of high-net-worth investors it knows well can be invited to participate in investments where they have relevant expertise and contacts. “These investors bring invaluable connections that we can leverage for growth,” he explains.

Proceed with caution

For all these upsides, however, all parties need to be conscious of some of the potential pitfalls of co-investments. That applies to both traditional partnership-type co-investments and arrangements set up by GPs and LPs. 

Above all, where co-investees have different ambitions, there is the potential for disagreements and disruption. That requires all parties to agree from the start on fundamental questions such as how the economics of the investment align, what happens if further capital raises are required or some form of write-down takes place, and the likely time horizons for an exit. 

Where LPs are investing directly into a co-investment, these considerations will typically be addressed through three separate documents, explains Chris Cowley, a partner in the private equity team at Taylor Wessing. These are the term sheet for the deal, which will set out the key points of the transaction, and then the subscription and shareholders’ agreement and the articles of association, which will set out the deal terms in long form. 

“The key for minority investors is economic alignment,” says Cowley. “Are they getting the same securities in the same proportions as the lead investor, with loan notes, for example, that are repayable or amendable only on the same basis? How are they protected from dilution: for example, do they have the right to participate, pari passu, in further equity fundraisings or a catch-up right if emergency funding is required? Do they have any exit rights of their own?” 

In some cases, GPs set up special-purpose vehicles to manage co-investments in a particular asset, which can be more costly but give them extra control. These structures are typically governed by a limited partner agreement that addresses the key issues, though some LPs may push for side letters that include particular terms.

In practice, however, no one wants to be relying on legal documentation, which is why GPs and LPs alike are picky about who’ll they invest with. “We are looking for predictable partners, which means we prefer to co-invest with people we know well,” says Mobeus’s Broomberg. “It is also key to avoid any issues that are going to interfere with the day-to-day management of the investment.”

Stay practical

In a traditional co-investment, each partner with a significant stake may look for board representation and a say in how the investee business is managed. Arrangements that are practical and provide the representation co-investees are looking for will need to be agreed in advance. 

By contrast, where LPs are investing alongside GPs, typically in addition to their fund exposures, there tends to be less scope for this shared input. “Very rarely would an LP become an operating partner or take a board seat,” says August Equity’s Patel. “In most cases, they’re not looking for this kind of ongoing management role.” 

Instead, Taylor Wessing’s Cowley stresses the importance of good reporting. “The co-investors won’t necessarily want to be involved in management, but they should demand a good flow of high-quality information keeping them up to date on the investment,” he says. “They may also want to agree how their voice will be heard when they do have views to express, for example through a board observer.”

In that sense, shared values are all-important. “Understanding your co-investor before you move forward is really important,” says BGF’s Snodgrass. “There are all the practical questions to agree about how the investment will be managed, but there also needs to be a meeting of minds on the approach to investment that you take.” 

Another consideration, says Patel, is that depending on how the internal decision-making is structured, a co-investee could hold up deal execution if they are not able to deliver on tight timelines. 

“There is going to be a certain amount of additional admin right in the heart of the transaction,” he warns. “We’ll aim to work with partners who can work to those timelines and have had similar experience before.” 

Still, many advisers say investors are becoming more sophisticated as their co-investment experience grows. They’re better able to work within the transaction timeline, even where they’re keen to conduct their own due diligence work. When LPs are investing alongside GPs, it helps that they will already have subjected the PE firm itself to a diligence process. 

In a market where co-investment continues to gather pace, that sophistication should continue to develop. And in any case, for many co-investees, the practicalities and challenges of the process are worth it, given the potential upside – exposure to larger deals, more attractive opportunities and, ultimately, stronger performance. 

“We are participating in more and more co-investment deals,” says Knight. “The expected returns on these investments can be higher.”