Private Equity Co-Investments: Are "Free" Options Worth It?

Free private equity co-investments are an increasingly popular opportunity for investors, but are they really free? Co-investments are typically offered on a no-fee, no-carry basis, allowing investors to avoid standard private equity fees and retain control over their capital deployment. However, the reality is not as straightforward, especially for smaller and midsize investors. Firstly, most limited partners (LPs) will not have access to the best co-investment deals as these opportunities usually arise when a deal is too large for a single fund. Secondly, despite being marketed as free, co-investments can incur various hidden costs, such as monitoring fees charged by private equity firms. Lack of fee transparency puts LPs at a disadvantage, and they may also lack the infrastructure and expertise to effectively evaluate and act on co-investment opportunities. While co-investments offer benefits such as reduced fees and increased control, investors should carefully consider the potential drawbacks and explore alternative sources for co-investment deals to maximise their returns.

Co-investments are not free from fees

Co-investments are typically offered on a no-fee, no-carry basis, but they are not entirely free from fees. While they are a sought-after private equity investment opportunity, there are some drawbacks.

Firstly, co-investments are only available to large institutional investors who have a relationship with the private equity fund manager, and they are often not available to smaller investors. This means that smaller investors will likely not get to invest as much as they would like, if at all.

Secondly, although an LP doesn't have to pay for the co-investment in a particular deal, there are many fees along the way that reduce the appeal of these opportunities. For example, monitoring fees can cost portfolio companies millions of dollars each year. There is also a lack of fee transparency, with hidden costs that can amount to millions of dollars.

Thirdly, many LPs lack the infrastructure to take advantage of co-investment opportunities as they do not have the in-house capacity or expertise to screen opportunities, perform due diligence, or negotiate term sheets. As a result, they may need to bolster staffing with analysts, adding further costs to the co-investment process.

Therefore, while co-investments can provide benefits such as exposure to new markets and reduced fees, they are not entirely free from fees and may not be suitable for smaller investors.

LPs may not see the best co-investment deals

The reality for most smaller and midsize limited partners is that co-investment deals are far less appealing than they may initially seem.

Firstly, most LPs will never get to see the best co-investment deals. Co-investment opportunities only arise when a deal is so big that a private equity fund decides not to fund the entire deal itself. This means that co-investment deals are inherently those that someone has already passed on. There is an entire investment food chain fighting for co-investment opportunities, with the biggest investors getting the best look at deals.

Most family offices or smaller institutional investors are only seeing deal opportunities that have been passed over by the bigger players in the market.

Additionally, even though an LP doesn't have to pay for the co-investment in a particular deal, there are many fees along the way that dim the appeal of these opportunities. Monitoring fees, for example, can cost portfolio companies millions of dollars each year. Private equity firms have come under increasing scrutiny by the Securities and Exchange Commission for fee abuses and fraudulent practices related to monitoring fees.

Moreover, many LPs simply don't have the infrastructure to take advantage of co-investment opportunities because they lack the in-house capacity or expertise to screen the opportunities, perform the due diligence, negotiate term sheets, etc. As a result, many of these LPs are having to bolster staffing with analysts who can provide this support, further adding costs to a co-investment process.

For these reasons, smaller and midsize LPs are likely better off looking elsewhere for co-investment deals that can provide the returns they seek.

Free co-investments can be costly

While co-investments are typically offered on a no-fee, no-carry basis, they are not always as "free" as they seem. Here are some reasons why the costs of co-investments can add up:

Limited access to the best deals

Most limited partners (LPs) will not get to see the best co-investment deals. Co-investment opportunities usually arise when a deal is too big for a private equity fund to fund on its own. This means that someone has already passed on the deal, and there is an entire investment food chain fighting for co-investment opportunities, with the biggest investors getting the best deals. Smaller investors often only see the deals that have been passed over by larger players in the market.

Hidden fees

Even though LPs do not have to pay for the co-investment itself, there are many fees along the way that reduce the appeal of these opportunities. Monitoring fees, for example, can cost portfolio companies millions of dollars each year. Private equity firms have come under scrutiny by the Securities and Exchange Commission (SEC) for fee abuses and fraudulent practices related to monitoring fees. Lack of fee transparency also puts LPs at a disadvantage, as they may be unaware of all the ancillary fees involved in a "free" co-investment opportunity.

Lack of infrastructure

Many LPs do not have the infrastructure to take advantage of co-investment opportunities. They may lack the in-house capacity or expertise to screen opportunities, perform due diligence, or negotiate term sheets. As a result, they may need to incur additional costs by hiring analysts or bolstering their staffing to support the co-investment process.

Competitive bidding and transaction fees

In the case of a competitive bidding process, bankers' fees can be as much as 7.5% or more, taken right off the top. Additionally, there may be transaction fees involved for originating the deal.

Long-term commitment and lock-up

To access co-investment opportunities, LPs typically need to commit capital to the private equity fund, which may involve paying fees and having their capital locked up for a long-term period, such as 10 years.

Limited investment amount

Smaller investors may not get to invest as much as they would like, or even at all, in co-investment opportunities due to their size and the pecking order of the investment food chain.

In summary, while "free" co-investments can provide certain benefits, such as reduced fees and more control over private equity portfolios, it is important to consider the potential hidden costs and limitations. These costs and limitations, including the likelihood of not seeing the best deals, the cost of long-term committed capital, and the possibility of not being able to invest as much as desired, suggest that smaller and midsize LPs may be better off exploring alternative investment opportunities that can provide the returns they seek.

Most LPs lack the infrastructure to co-invest

While co-investments in private equity are typically offered on a no-fee, no-carry basis, they are not truly free. LPs or limited partners need to consider the ancillary fees and tactics involved when evaluating the cost of a "free" co-investment opportunity.

One of the challenges of co-investments is that most LPs lack the necessary infrastructure to take advantage of these opportunities. They often lack the in-house capacity or expertise to screen and evaluate potential investments, perform due diligence, and negotiate term sheets. As a result, they may need to incur additional costs by hiring analysts or consultants to provide this support, which can further add to the overall cost of the investment.

In addition, co-investments require LPs to have additional resources and experience to assess individual deals effectively. This includes the ability to make quick decisions based on thorough assessments of the opportunities. Without the necessary infrastructure and expertise, LPs may struggle to fully capitalise on co-investment opportunities.

Furthermore, the competition for co-investment opportunities is intense, with smaller investors often missing out on the best deals. The biggest investors usually get the first look at the most attractive deals, leaving smaller players with less desirable options. This dynamic can further disadvantage LPs who lack the infrastructure and resources to compete for the top co-investment opportunities.

Overall, the lack of infrastructure among most LPs can hinder their ability to effectively participate in co-investments and may result in additional costs or missed opportunities. It is crucial for LPs to carefully consider their capabilities and seek appropriate support to make informed decisions about co-investments in private equity.

Co-investments may not be suitable for smaller investors

Secondly, smaller investors may not have the necessary infrastructure and expertise to effectively evaluate and take advantage of co-investment opportunities. They may lack the in-house capacity or knowledge to screen opportunities, perform due diligence, or negotiate terms. As a result, they may need to incur additional costs by hiring analysts or specialists to support them in the process.

Additionally, smaller investors may face challenges in terms of deal access and selection. Co-investments are often offered to larger investors first, and by the time smaller investors get an opportunity, the deals may have already been passed on by bigger players in the market. This can impact the quality of deals available to smaller investors.

Furthermore, while co-investments are typically offered on a no-fee or reduced-fee basis, there may still be various ancillary fees and costs associated with the investment. These can include monitoring fees, transaction fees, and management fees, which can add up to significant amounts. Smaller investors, with their limited resources, may find these costs burdensome.

Lastly, co-investments require careful consideration and quick decision-making. Investors need to have the experience and resources to assess individual deals effectively and make timely commitments. Smaller investors may struggle to keep up with the pace and complexity of co-investments, potentially putting them at a disadvantage.

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