LPs play hardball in negotiations with GPs

An interesting tension has arisen with limited partners and co-investing.

An investor relations professional, who has been busy the past year with fundraising, says that LPs have started taking a hardball stance in negotiating terms of co-investments, in a way the IR professional has never seen before. LPs are working to ensure that they retain the no-fee, no-carried interest structure on their co-investments in situations where the co-investment is the target of a continuation fund deal.

The co-investing LPs are trying to guarantee they won’t be faced with the option to potentially sell at a discount or roll on the new terms of the continuation fund that likely include fees. They are essentially looking for the same kind of “status quo” option on their co-investments that fund LPs look for when considering rolling into a continuation fund.

Gone are the days of easy re-ups

It’s a negotiation that often fails in part because the market hasn’t yet found a standard, sources tell Buyouts.

“If the selling price is too low, [LPs] don’t want to be forced into a continuation fund with new terms, they want to be able to do nothing,” the IR professional says.

“There were very few GPs thinking about this back in 2021. Now is really the first year where people are wondering, ‘Well, how is my co-investment going to be treated?’”

Neha Champaneria Markle, Morgan Stanley

The IR professional says these concerns are drawing out negotiations around co-investments and keeping shops like hers busier than ever.

This theme – how co-investors are treated in relation to continuation funds – is rippling across the industry as co-investing activity picks up and the popularity of GP-led deals explodes.

“This is a subset of a topic when we’re co-investing we focus on acutely, which is alignment,” says Seth Palmer, a managing director at HarbourVest Partners who focuses on co-investing.

“We want pre-emptive rights to sell when the GP sells, to invest more when the GP invests more. As we introduce a new form of exit or liquidity to the market, we need to consider what pre-emptive rights or protective rights look like with that new exit. The market wants to continue to support continuation funds … and will reach a healthy outcome here and healthy market standard,” Palmer says.

59%

Percentage of LP respondents who plan to increase allocations to
co-investments over the next two to three years, according to a recent survey by Goldman Sachs

The negotiation is very much of the moment. In the slow fundraising environment, limited partners are taking more time to understand the terms of their relationships with PE managers, even those they’ve worked with for a long time.

Due diligence processes run by LPs on new funds, even on re-ups to their long-standing relationships, have grown more robust. Gone are the days of easy re-ups, sources say. Now, LPs are looking for any reason to move on to the next opportunity.

With closer scrutiny, LPs have been pushing back on certain terms and conditions they’ve long felt were too GP friendly and that misalign their relationships. “There’s some terms that skewed a little bit out of whack toward the GPs’ favor in terms of fairness and we’re looking to bring those back to the center,” Scott Ramsower, head of private equity funds at Teacher Retirement System of Texas, told Buyouts last year.

Co-investing is top of mind in this negotiation, as it has become a vital part of the relationship between many GPs and LPs. According to fresh research from Goldman Sachs, 59 percent of LP respondents to a recent survey plan to increase allocations to co-investments over the next two to three years. At the same time, 58 percent of LP respondents have zero allocation to co-investments, meaning there is a lot of pent-up ­demand that could be coming to the market.

“We’re always looking for alignment, evidence that we’re on the same side of investing in the private markets”

Andrea Auerbach, Cambridge Associates

As GPs open access to co-investment opportunities, the way these agreements are offered and managed is coming under closer scrutiny.

“There were very few GPs thinking about this back in 2021. Now is really the first year where people are wondering, ‘Well, how is my co-investment going to be treated?’” says Neha Champaneria Markle, head of Morgan Stanley private equity solutions.

A few years ago, how co-investments were treated in the context of a continuation fund was not an issue because co-investments were not a large part of secondaries deals. Single-asset continuation funds didn’t start to gain popularity under the pandemic era of 2020.

60%

LP secondaries as a percentage of total deal activity in H1, according to Lazard

Both strategies have exploded in popularity. Around 48 percent of LP respondents to Probitas Partners’ 2023 trends survey reported an active co-investment program, with 86 percent of large investors reporting in the affirmative. Around 24 percent of LP respondents said they only co-invest with fund managers with which they already have a relationship.

Many LPs have set up formal programs for co-investing, appointing dedicated professionals to run the strategies. This structure is necessary for LP institutions to be able to vet potential opportunities in a timely manner.

“Why do LPs co-invest? Because it’s usually cheaper; they can put more money to work faster,” says Andrea Auerbach, head of global private investments at Cambridge Associates.

Co-investment usually occurs between the GP and an LP that is also an investor in the GP’s main fund, with a smaller percentage of co-investments coming from external third parties.

For LPs, co-investing is a way to get to know the GP on a more intimate basis than a passive fund commitment. And it’s usually made without the LP being charged management fees or carried interest, or at least reduced fees.

This serves to draw the two parties closer together and allows the LP to increase private equity exposure while lowering the cost of the asset class.

“It’s not one size fits all,” says  “If a GP-led happens, some co-investors say, ‘Automatically cash me out, we’ll take our cash now.’ And some LPs say, ‘Our default will be we’ll stay in alongside the GP'”

Isabel Dische, Ropes & Gray

For GPs, co-investing has been a way to build closer relationships with LPs; to source equity for deals, especially those that might be too big for the regular fund. And in today’s market, marked by more expensive debt, co-investments have become more important as GPs need to contribute more equity to their deals.

Around 95 percent of 95 GP respondents to a July survey from Churchill Asset Management expect to maintain or increase their use of co-investment.

“LPs… have the highest interest in co-investment opportunities, reflecting the rising desires of LPs across the industry to establish deeper relationships with fewer favored GPs,” Francis Idehen, partner and US head of alternative multi-strategy solutions at Goldman Sachs Asset Management, says in the survey report.

Single-asset secondaries, which for a time became the most popular secondaries strategy, is primarily the type of structure that would interact with existing co-investors. GP-led secondaries such as single-asset deals have faded a bit in the market downturn, even as secondaries as a strategy grows in popularity.

Secondaries came second in popularity in Goldman’s survey, with 48 percent reporting they would increase exposure to the strategy.

“GPs are best served by doing right by their LPs and their co-investors over the long term vs winning a particular point in a particular transaction”

Seth Palmer, HarbourVest Partners

“Increased exposures by LPs to secondaries and co-investments, some building over a decade or more, are natural evolutions in private markets,” says Michael Brandmeyer, partner and co-head of Goldman Sachs Asset Management’s external investment group. “Expanding numbers of sophisticated LPs now have the resources and expertise to access these strategies as part of their core allocations.”

LPs use secondaries as a portfolio management tool, to exit out of non-core relationships, to sell down exposure and keep their allocation percentage in balance. LP secondaries has driven activity over the past year, representing about 60 percent of total deal activity in the first half, according to Lazard.

GP-led activity has remained muted, though inventory on the market is robust, with many GPs looking to extend their holds over certain treasured assets. GP-led deals generally require the LP to decide whether to sell out of their interest in the asset or assets or roll their interest into a special purpose vehicle for more time and capital to grow the business.

The SPV, or continuation fund in industry parlance, often is created with a new fee stream and potential for carried interest. It’s this structure that is raising concerns with co-investors.

How it works

As in many areas of private equity, LPs are focused on alignment when it comes to co-investment and continuation funds. Deals that look like fee grabs aren’t going to engender much support from LPs, co-investors or otherwise, according to Champaneria Markle.

“We’ve seen more than a few continuation vehicles where there is no fee. When I put on my LP hat, or my co-investor hat, that is a very strong indication of conviction,” she says. “They’re not setting it up to increase their fee base, they’re setting it up because they truly believe it’s a trophy asset.”

Explains Auerbach: As LPs, “we’re always looking for alignment, evidence that we’re on the same side of investing in the private markets.”

Egregious terms like the ability for a GP to “drag” a co-investor into a continuation fund that charges new fees would not be viewed by most LPs as aligned.

That sort of aggressive term is rare, sources tell Buyouts, but not unheard of.

More common is simply a co-­investor’s desire to stay on the same terms they already had in the co-investment. This is where the negotiation comes in.

The terms on such deals vary firm to firm (as is the case with most things in PE land). In some cases, co-investing LPs may negotiate “pre-emptive” rights to follow the main fund’s exit activity; some co-investors may get automatically cashed out in an exit scenario; some co-investors even want approval rights of continuation fund deals involving their asset, ­sources say.

95%

Portion of GP respondents who expect to maintain or increase their use of co-investment, according to a July survey from Churchill Asset Management

Ideally, co-investors, like any LP, want optionality. They would like the choice to sell or stick with the asset if they believe in it and see more growth ahead, even if that means agreeing to a new set of fees, sources say.

“It’s not one size fits all,” says Isabel Dische, chair of the alternative assets opportunity group at law firm Ropes & Gray. “If a GP-led happens, some co-investors say, ‘Automatically cash me out, we’ll take our cash now.’ And some LPs say, ‘Our default will be we’ll stay in alongside the GP, but in particular if we get moved to a new continuation vehicle, our side letter needs to move to that vehicle as well and it can’t start paying economics if we’ve been carry/fee free.’

“There’s a menu of ways we’ve seen investors approach GP-leds.”

Achieving the “status quo” option seems to be high up on many co-investors’ lists, but such a structure is not granted with much frequency. Investors must fight for it, and, as one co-investor said, they get it at most half the time they ask for it.

It’s possible the market will move toward a more routine status quo option for co-investors faced with continuation fund deals, but who knows? As it’s always been in private equity, every firm has its own way of dealing with its LPs. Those that get it right are the ones that have a big advantage in raising the next fund.

“GPs are best served by doing right by their LPs and their co-investors over the long term vs winning a particular point in a particular transaction,” Palmer says.

“I’ve observed that the top quartile GPs, the best GPs, ­appreciate that fact and have a long view on a relationship as do we as co-investors.”

Continued momentum

Boston investment, advisory and research firm Cambridge Associates recently published a white paper called Six Things to Know About Co-investments, written by Scott Martin, Nick Warmingham and Jacquelyn Klehm. Michael Schoeck spoke with Martin, who serves as managing director, to find out more.

Why are co-investments on the rise?
Co-investments can be episodic. The last time they were used was pre-great financial crisis. People have now started to lean into them in both thoughtful and programmatic ways. In terms of how GPs are using them, they’re using them because of the slowdown in M&A activity. It’s more costly to do deals and it’s beneficial to the LP with co-investing more likely to re-up between fund managers. You have LPs that want co-investments and, with the market being more saturated with debt fueling transactions, it’s more expensive overall. Secondly, co-investments facilitate buy-and-­build strategy deals. A GP will go to the LP and say, “We need more capital now, and some reserved for later.” We’re seeing continued momentum in this regard.

Which sectors are seeing a lot of co-investments?
We are seeing strong deal activity in software, all types, because of high cashflow and lots of recurring capital returns. We’re seeing it in infrastructure as well, like road maintenance, wastewater treatment transactions. We’ve seen financial services transactions, like insurance. And there have also been co-investments in education, training nurses in key areas, as well as advertising and marketing services – not just a technology looking for clicks, but looking for buying decisions, something that directs people online to a mutual fund or credit card, for instance, that has tangible returns on investment.

What about deal size?
We’re seeing activity take place within growth equity and mid-market co-investments from $100 million to about $1 billion. PE investors with large investment portfolios (greater than $1 billion of net asset value) will likely have a sufficient number of GP relationships that are more likely to have significant LPs in funds such that GPs will oblige when they start asking to see co-investments. For smaller investors with portfolios below $200 million of net asset value, sourcing sufficient co-investment dealflow can be more difficult.