The popularity of co-­investment has soared over the past decade. For LPs, it has provided an efficient way to access a high-performing asset class – doubling down on stellar managers and high-returning investment themes, but without stumping up the additional fees.

“LP appetite for co-investment continues to be strong, driven by a desire to gain or build exposure to certain sectors or certain managers and to average down net fee loads,” says Ophir Shmuel, managing director and head of EMEA at Eaton Partners.

“LP co-investment appetite is strong and continues to grow as the asset class matures,” adds Arslan Mian, managing director, Private Equity Partners, at BlackRock. “There are a number of drivers, including LPs’ desire to exert more control over portfolio construction and investment pacing, deepen their relationships with GPs, and invest with reduced economics. Evaluating co-investments also provides great insights into a GP’s underwriting process, which can inform an LP’s primary fund diligence.”

And while fair weather co-investors may have temporarily hit pause due to macroeconomic volatility, the reality is that many institutions have professionalized their approach to co-investment in recent years and have fully embraced the co-investment opportunity – driven, in part, by a fear of missing out.

“Many LPs that did not historically co-invest have grown tired of effectively subsidizing those that do,” says Capital Dynamics’ senior managing director, Andrew Bernstein. “They have now built out their own teams or partnered with specialists in an effort to blend down fees as well as deepen their relationships with GPs. LPs can use co-investment to see how the sausage is made in order to better inform their decisions on the primary side.”

For GPs, meanwhile, co-investment has proved highly preferential to the convoluted club deals that dominated in the run-up to the global financial crisis. “Offering co-investment allows the GP to invest in deals requiring more equity than it would want to hold in its fund, given fund size and portfolio construction constraints. Filling an equity gap with LP co-investment provides for more aligned governance than sharing control with another GP, and GPs may prefer sharing the upside with their LPs rather than a competitor,” says Andrew Farris, managing director, Private Equity Partners, at BlackRock.

Tensions building

Co-investment has also proved to be a powerful fundraising tool. “Offering co-investment can be helpful for fundraising, as many LPs consider co-invest potential when evaluating primary fund commitments,” Farris says. “Furthermore, a knowledgeable and strong co-investor can bring more to the table than just capital, including its network and industry insights.”

But there are signs that this happy equilibrium may be shifting. In particular, a surfeit of co-investment supply means that GPs that have relied on the offer of co-investment to secure LP commitments, are being forced to recognize that this may no longer be enough to tie investors into funds.

“For managers relying on co-invest to get their funds raised, I would say that the jig is up,” says Rishi Chhabria, partner at Campbell Lutyens. “LPs today are inundated with co-invest opportunities and it is therefore a lot harder to command their ­attention and get your fund closed based on co-invest alone.”

Some GPs are becoming more generous with economics as a result. Typically, an LP will receive $1 of co-investment on a management fee and carried interest-free basis for every $1 invested in the fund. According to Chhabria, this is being extended to $1.50 or $2 fee-free for every $1 invested, in some situations.

However, co-investments alongside well-established, high-performing sponsors, often result in more demand from LPs than available supply. In these situations, it is co-investment allocation strategies that can sometimes create tensions, particularly if GPs are seen to be unfairly allocating co-invest to institutions that could become new investors in their funds.

“Co-investment is a route through which LPs get to know GPs and potentially make the decision to invest in future funds,” says Joshua Cherry-Seto, CFO of venture capital firm StartUp Health and until recently of Blue Wolf Capital. “That could mean a GP is incentivized to offer co-investment to those investors in order to support future fundraising. There are typically policies in place governing how co-investment is awarded but those policies, and the extent to which they are adhered to, are coming under increasing scrutiny.”

Nathalie von Niederhaeusern, managing director, Private Equity Partners, at BlackRock, adds: “GPs have varying methods of deciding who sees co-investments and how they’re allocated. Factors can include the ability to invest with the necessary speed and scale, status as an existing or prospective LP and size of overall relationship.

“GPs usually prioritize current LPs, but they sometimes reserve allocation for potential new LPs. That may not seem ideal to existing LPs, but private equity is a long-term relationship business. It can also be beneficial for co-investors to have sector expertise, enabling them to guide GPs on areas of interest, and quickly ramp up on diligence and gain conviction. It’s tough to make everyone happy in allocation processes, but GPs generally try hard to be fair.”

A proliferation in co-investment is also causing some consternation among fund investors who rarely or never participate in co-investment, however. “LPs that are not active co-investors are getting frustrated when they find themselves signing up to a $400 million fund where the GP is actually investing $800 million or more, because of the level of co-investment being offered,” Chhabria explains. “They make their commitment thinking they are going to represent 10 percent of the fund, only to find out that they represent 5 percent. Unless extensive co-investment is actively marketed as part of the strategy, that can cause some tension.”

Enter the SEC

Indeed, SEC chairman Gary Gensler has made no secret of his plans to bring enhanced disclosure to a private equity industry he believes is now too big to fail. And, it appears, co-investment is firmly in his crosshairs. The danger, of course, is that the SEC fails to recognize either the nuances or the ultimate benefit of co-investment to the underlying investor community.

Growth in co-investment in recent years has primarily involved passive syndication rather than co-investors co-leading transactions alongside sponsors. “Only a small minority of investors have the resource and capital to co-lead deals and while there may be new players moving into this end of the spectrum, the majority of co-investment deals done will be syndicated,” says Shmuel. One co-investor, who declined to be named, said that they believe it is important that the SEC recognizes these essential differences when deciding on its approach. “I am hopeful that regulators will be cognizant of the differences between large co-investors that underwrite deals and smaller passive co-investors,” they say. “I also hope that they are sensitive to the proportionality of the benefit that investors get relative to their size, role in a deal and the risk that they have taken.

“I think it would be unfortunate if the SEC took a position that had a cooling effect, either on the provision of co-investment or on the willingness of LPs to co-invest, because co-investment is hugely beneficial to both LPs and GPs,” they add. “And I hope that whatever decision the SEC takes in pursuing its worthy goal of protecting underlying investors and driving transparency in the market, does not have the unintended consequence of creating an investor unfriendly outcome.”

Anne Anquillare, head of US fund services at CSC, agrees. “I hope the use of co-investment isn’t regulated out of the market because it is an important tool,” she says. “But, it is a tool that must be used and communicated appropriately, if it is to continue to have a role in this industry.”

Co-investments and broken-deal fees

Perhaps the most controversial aspect of co-investment is the vexatious issue of broken-deal fees when it comes to transactions slated to included co-investment capital.

“The issue of how dead deal fees are shared continues to be debated in the market,” says Joshua Cherry-Seto, outgoing CFO at Blue Wolf Capital. “The fund typically bears the cost, but if a proportion of the capital earmarked for the deal was never going to come from the fund, should that expense not be shared?”

“The industry doesn’t seem to be reaching any consensus as to how fees and expenses should be dealt with in these situations,” adds Anne Anquillare, head of US fund services at CSC. “And when the industry is unable to reach a consensus on a sensitive topic, that is typically when the regulator intervenes.”