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Private Equity

Two Ways for LPs to Co-Invest, and Why It’s Worth It

Limited Partner (“LP”) co-investing is on the rise. Among LPs profiled on Preqin’s Private Equity Online, 42% actively make co-investments and a further 12% are considering doing so. Through the beginning of December 2016, nearly $103 billion worth of transactions involved direct LP dollars — the highest figure since 2007 — and more than double the $43 billion in transactions in 2015, according to PitchBook.

The premise of LP co-investing is simple: a limited partner makes a direct investment into a portfolio company alongside other financial investors, often a General Partner (“GP”) whose traditional fund they already back.

Co-investments bypass the well-defined agreements of a traditional fund and have very different terms. Notably, there’s often no management fee or carried interest — even if the LP is paying the standard 2-and-20 fees on the traditional fund.

Apart from lower or no fees, a co-investment lets an LP see and negotiate the terms, get access to better and more varied deal flow, more easily track a company’s performance, and see returns that are around 5% higher than for a traditional PE fund. It’s an increasingly popular strategy as LPs look to take more active roles in the PE asset class, and as GPs look to share more risk and capital related to deals — while strengthening their relationships with LPs.

We talked to David Howe, CEO of Scout Partners LLC, about two ways LPs can structure a co-investment, and what to look out for.

Howe says he likes co-investments because they allow him to invest in a more strategic way. “It’s a great benefit to be able to choose investments that capture a preferred industry, terms, geography and overall risk-adjusted returns.”

Here are two ways an LP can approach their co-invest strategy:

Direct Co-Investing

The first way to co-invest is directly with an operating company or holding company, often without any fees or carry. This simple structure can produce better economic returns and give LPs better control over their investment.

Here’s an example: A $750 million growth fund might pick five platforms, each with an enterprise value around $200 million and each with specific diversification characteristics. The partnership agreement might limit fund investments to $125 million for each company (meaning the firms would be levered up for the remaining $75 million). If a wonderful new possible platform were to show up with an enterprise value at $325 million, the GP would need to look outside its standard fund structure to make a move. It can only invest $125 million directly and it might borrow another $75 million to $125 million for financing, then offer co-investment opportunities to existing LPs or outside parties.

The positives of a direct investment are that the LP — who is now a stakeholder in the company — can decide how involved he or she wants to be before and after the deal.

At the due diligence phase, the LP may want to go through the materials as if they were the lead investor. And depending on his or her investment philosophy, an LP may seek customary minority stockholder rights, including preemptive rights, tag-along rights, information rights, registration rights, and so on.

Some LPs may want to take an even more active role — perhaps at the board level, or by negotiating observation and consent rights with respect to certain actions.

The downside of a direct co-investment is that it can require extensive expertise to pull it off successfully, particularly in the middle market. Unlike mega deals, which come much more prepackaged from the larger sponsors, middle-market deals require more attention. LPs who co-invest are essentially screening and managing their own portfolio program.

Without the right expertise, a deal can blow up, in which it’s the co-investor’s reputation that’s on the line.

Sidecar Vehicles

If an LP is merely looking to reduce fees, rather than take active control, they can co-invest using a sidecar vehicle, also known as a special purpose vehicle.

Here, the co-investment fund is set up as a LLC or LP, which gives it pass-through abilities and puts the vehicle under the GP’s control. To maintain alignment, sponsors and sidecar LPs negotiate a number of common protections like entry and exit rights.

With a sidecar, an LP gives full discretion to the GP, who automatically co-invests pro-rata into every deal on a low-fee basis and carried interest allocations. Or a GP may operate a separate account in which he or she picks and chooses co-investments on behalf of the LP.

The advantage of a sidecar is it provides LPs with better fee economics. It’s also a lot less legwork than having to scrutinize every single co-investment opportunity — especially if the LP lacks the required expertise. Finally, it’s easier for an LP to deploy capital within a sidecar structure vs. a formal fund.

The downside is that GPs typically have a larger commitment to the main fund vehicle than to a sidecar (they won’t lose any money if the sidecar doesn’t work out, since they don’t contribute to it). LPs also have to pay a fee of 1% to 10% to the GP to manage the investment.

Furthermore, a sidecar can create conflicts of interest if the GP collects carry (usually 10% to 20%) on the sidecar before the main fund reaches hurdle. The carried interest can be negotiated, but some LPs prefer that the GP receives carry so that he or she is properly motivated to make the sidecar successful, says Todd Lowther, a partner at law firm Thompson & Knight LLP.

Ultimately, a sidecar can be a good way for high net-worth individuals, families, or other investors to invest in funds and then rely on those funds for access to follow-on investments, as long as LPs ensure their rights as an investor are being met.

Conclusion

Co-investment is a way for LPs to play the PE asset class and reap the alpha. If an LP is investing in the primary fund, too, being able to get closer to the deal — how it’s sourced, structured, and managed — adds an invaluable layer of information to their work.

But co-investing is not for amateur LPs, says Howe, who has 31 years of investing experience. “You need to have access to the opportunities, which today still means having the right GP relationships, and you need to understand the underlying risks,” he says. LPs should be sure to invest with an experienced GP that they know and trust.

For aspiring co-investors who have strong experience in a particular industry, and the time and dedication to source and evaluate the right opportunities, the much-heralded grand prize — healthy, risk-adjusted returns  — is worth the sweat.

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