Exploring the Trends of Co-investments in Private Equity

What are Private Equity Co-Investments?

In private equity, co-investments allow investors to directly invest in a private equity deal alongside the private equity fund, usually acquiring a minority stake with the expectation of generating returns.

Investors are typically limited to extremely high net worth individuals or large institutional investors (such as pension funds or insurance companies) with an established relationship with the PE firm. 

Investors commit capital to a specific deal, providing additional equity to the private equity firm, which helps fund the transaction while also distributing risk.

Co-investments are a strategic tool that private equity firms use to share investment opportunities with key investors and optimize fund allocation. Co-investments help PE firms close larger deals, strengthen investor relationships, and optimize capital deployment without over-concentrating the fund..

Large institutional investors often prefer co-investments because they eliminate traditional fund management fees and provide direct exposure to a specific deal instead of a broadly diversified fund.

Understanding Co-Investments in Private Equity

As a result of the investor’s minority stake in the target company, the private equity firm typically controls operations and strategic decisions aimed at increasing profitability. In other words, the investor cannot make any decisions about the fund. 

As mentioned above, a co-investment occurs when the investor focuses on a single company, heightening the risk of the transaction while simultaneously reducing management fees and carried interest, leading to higher potential returns. 

Unlike investing in a private equity fund, co-investments require additional due diligence from the investor. This includes internal expertise to assess risk, valuation, exit strategies, and general industry trends. 

Co-investment opportunities often arise quickly, requiring investors to conduct due diligence and make decisions within a limited time frame.

Oftentimes, private equity firms will keep their most promising opportunities within their main fund and offer their lower-quality deals to the investors, and on top of that, only the most trusted investors with an established relationship and reputation will get the chance to co-invest. 

In recent years, many institutional investors have increasingly participated in co-investments to benefit from lower costs and direct exposure to specific deals. Some large institutional investors even build teams dedicated to private equity to carry out investments more efficiently. 

Advantages of Co-Investments

There are several advantages to co-investing with a private equity fund, which is the primary reason for its rising popularity in recent years. 

For example, co-investments have several advantages, such as reduced fees and choice of investment, making co-investments increasingly more attractive to investors. 

Let’s understand a few advantages below:

1. Direct exposure to specific deals: Investors can select deals they find attractive and potentially profitable, unlike in a traditional PE fund, where investments are pooled and allocated by the fund manager 
2. Lower Fees: Many co-investments do not charge management fees (typically 1.5-2% in funds) or carried interest (often 20% in funds), which can lead to higher net returns. Additionally, since co-investments have lower fees, there is a potential opportunity for higher net returns.
3. Portfolio Diversification: While being involved in one or a few co-investments can lead to a lack of diversification, investors can diversify across multiple private equity firms, sectors, and deal types (LBO, IBO, etc). Through co-investments, investors can avoid undesired industries, or just industries that they think are too risky or simply a dangerous investment.
4. Strengthens Relationship with Private Equity Firms: Co-investing with a private equity firm tightens the bond between the institutional investor and the PE firm, thereby giving the investor greater access to future deal flow and exclusive opportunities
5. Due Diligence and Transparency: When involved in a co-investment, investors receive detailed financial reports, business plans, and risk assessments for the deal, providing greater insight than traditional PE funds. This also gives the investor a greater understanding and insight into the investment structure and overall terms of the deal than a standard PE fund.

Disadvantages of Co-Investments

Just as there are advantages for co-investments, there are just as many disadvantages despite the continued prevalence of co-investments. Some disadvantages include:

1. Heightened Concentration of Risk: Even if the institutional investor diversifies their portfolio across several co-investments, the invested capital is still heavily concentrated in only a few investments, increasing the transaction risk. Additionally, even if one of the co-investments made by the investor underperforms, there will likely not be enough diversification to offset the loss.
2. Due Diligence Requirements: While co-investors gain access to deal-level financials, they must independently assess valuation, risks, and exit strategies. Without proper expertise, the investor may not be able to fully comprehend the deal taking place and understand all the risks associated with it.
3. Limited Deals & Deal Flow: Many private equity firms do not offer co-investments, and those that do often see high competition among institutional investors for access to top deals. Therefore, to have access to the co-investment deals, the investor must have quite a strong standing with the private equity firm to access those types of opportunities. 
4. Illiquidity of Co-Investments: One major drawback is that invested capital remains locked up for the duration of the deal, with no liquidity until the exit strategy is executed 
5. Conflicts of Interest: Private equity firms typically offer co-investments to investors on deals they want to lessen the risk. In other words, many firms will only offer co-investments on extremely risky deals they want to make safer for themselves.
   • This can lead to a conflict of interest because the investor wants to make the safest investment possible while maximizing their returns, but that is often difficult to accomplish when the PE firm offers an already dangerous deal.

Case Studies of Co-Investments in Private Equity

Even though co-investments are becoming increasingly common, they are not something new to the private equity industry and have been occurring for quite some time. 

The following three examples illustrate real-world examples of co-investments in private equity necessary for the acquisition. 

Alpinvest Partners’ Co-Investment Acquisition of AMC Theaters (2004)

Alongside J.P. Morgan and Apollo Global Management (who were the institutional investors in the case), Alpinvest acquired AMC Theaters in a deal valued at $2.0 billion. AMC was then delisted, and shareholders were paid $19.50 per share.

At the time, AMC was a leading company in the movie theater industry, and Alpinvest had a plan to revamp its operations and put it back on the public market as an exit strategy.

KKR’s Leveraged Buyout of RJR Nabisco (1988)

Alongside numerous institutional investors, which included several pension funds and endowments, KKR acquired RJR Nabisco, a company that sold tobacco and other food products, in an LBO valued at $31.1 billion, the largest LBO in history at the time.

This LBO in 1988 was quite representative of the corporate acquisition “frenzy” taking place in the 1980s. Additionally, it held the record for the largest LBO in history for 17 years. 

TPG Inc.’s  Co-Investment Acquisition of Petco (2000) 

Alongside the institutional investor Leonard Green and Partners, TPG (a private equity firm) acquired Petco, a pet supplies and food company, in a deal valued at $600 million. 

This acquisition was a leveraged buyout, meaning that it was largely financed by debt, but still required co-investments to raise the necessary capital.

General Trends of Co-Investments in Private Equity

In recent years, the demand from institutional investors has steadily increased due to the financial attractiveness of co-investments from the institutional investor's perspective. 

Generally speaking, the reduced fees, significant returns, and overall control over the deal make co-investing an extremely appealing venture for institutional investors. 

Due to this growing appeal, competition for co-investments has intensified, favoring firms with strong brand recognition or close ties to PE firms.

Nevertheless, co-investments aren’t just appealing to institutional investors; they are also equally beneficial to the private equity firm. 

PE firms can strengthen their relationship with investors and gain access to larger deals because institutional investors allow PE firms to raise additional capital. 

Furthermore, co-investments allow PE firms to diversify their risk portfolio because they are able to take on more risky investments when they “transfer” some of the risk to the institutional investor.

Summary

Co-investments in private equity represent a slightly riskier alternative to traditional investments in “main” private equity funds and introduce the prospect of “deal choice” to institutional investors. 

Co-investments allow the institutional investor to have greater control over where their invested capital will end up, in addition to being included in some of the deal's financials. 

Furthermore, co-investment opportunities often arise because a private equity company wants to de-risk an already risky investment by bringing on an institutional investor to put more capital and stake into the mix. 

Conclusively, the private equity industry has seen a sharp increase in co-investments in recent years, primarily driven by PE firms and institutional investors' desire for greater profits and increased risk. 

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