Private equity co-investment opportunities have generated a 27.1% internal rate of return over five years. Traditional private equity fund commitments only reached 18.9% during the same period.
These impressive numbers explain why 80% of limited partners get better results from equity co-investments than traditional fund structures. The strategy’s popularity shows in the numbers – about $50 billion in total private equity co-investment activity happened in 2022 alone. What does co-investment in private equity really mean? The strategy lets you invest directly with general partners in specific companies. It often comes with lower fees and typically runs on a no management fee, no carried interest basis.
Private equity co-investments can make up 15% to 30% of your total private investment allocation. This gives you tactical flexibility and helps you control deployment pace while increasing exposure to specific sectors or regions. The approach brings its own challenges that need careful thought.
This piece will help you become skilled at navigating the private equity co-investment world. You’ll learn to build a strong strategy that lines up with your investment goals, whether you’re thinking about a direct investment private equity approach or looking at a co-investment fund structure. We’ll also show you how to avoid common mistakes that catch even seasoned investors off guard.
Step 1: Understand What Co-Investment in Private Equity Means
Learning the basics of co investment private equity should be your first step before you explore this specialized investment approach. The market value of private equity co-investing has grown by a lot, reaching about $60 billion and making up around 20% of market activity.
Definition and structure of private equity co-investments
What is co-investment in private equity? You make a minority investment straight into a privately owned company right next to a private equity firm (the general partner or GP). This means you put your money directly into the portfolio company instead of the fund itself.
The setup works in two main ways. The GP usually creates a special purpose vehicle (SPV) where you make your commitment. This SPV works like a primary fund structure but holds just one asset. You might also buy equity in the company directly, which brings up extra tax and governance questions.
Your role as a co-investor is mostly hands-off. You won’t run daily operations, but legal and structural protections will keep your investment safe. Recent numbers show this strategy has caught on – almost two-thirds of institutional investors plan to invest alongside their GPs.
How co-investments differ from traditional fund commitments
Private equity co-investments are different from traditional fund commitments in several vital ways:
You invest in one specific company rather than spreading money across the fund’s whole portfolio. This lets you control your exposure to specific sectors, locations, and investment strategies.
The fee structure makes a big difference. Co-investments often come with lower fees or none at all, including carried interest. This explains why many investors use this method to boost their returns. Family offices and institutional investors love this advantage – 42.5% of family offices already use this approach.
You can build a portfolio with GPs of all sizes, countries, and industries. About 25-30 companies give you good diversification. This focused strategy lets you access promising private firms directly instead of using fund-of-funds investments.
Common types: syndication vs co-underwriting
The private equity co-investment world has two main approaches: syndication and co-underwriting.
Syndication happens when the GP invites certain LPs to join after buying a company. This usually takes 4-6 weeks from first contact to investment. These deals come in at a steady pace without much pressure.
Co-underwriting has grown as LPs got better at handling deals. The GP asks you to join while they’re still competing for an asset. You must decide faster (usually 3-4 weeks) without knowing if the deal will work out. Deal volume in this area has grown five times in the last two decades.
Co-underwriting asks more from investors. You need risk assessment skills and must be ready to handle failed deal costs and offer strategic value. This is a big deal as it means that these deals perform better, with an average gross TVPI of 2.7x compared to 2.2x for post-signing deals.
Step 2: Evaluate the Benefits and Risks for LPs
A good understanding of both potential benefits and risks is vital for making informed decisions about co investment private equity opportunities. Unlike traditional fund investments, co-investments present a compelling value that deserves a thorough look.
Lower fees and better net returns
The biggest advantage of private equity co-investments lies in their fee structure. GPs usually give their LPs co-investment opportunities without management fees or carried interest. This creates a stark difference from traditional private equity funds that charge management fees of 1.5% to 2.0% plus 20% carried interest on profits above an 8% hurdle rate.
The economics stay favorable even with co-investment funds instead of direct co-investments. These specialized vehicles usually charge about 1.0% in management fees with carried interest between 10% to 12.5% on an 8% hurdle return. So this fee efficiency directly improves net returns.
The effect on performance can be substantial. Former CalSTRS CIO Chris Ailman reported that while private equity fund commitments yielded a five-year IRR of 18.9%, co-investments reached an impressive 27.1% IRR during the same period, saving over $780 million since 2017. Research shows that more than 60% of co-investment deals outperform the net Total Value to Paid-In Capital (TVPI) of parent funds.
Access to high-quality deals and GPs
Private equity co-investment offers strategic advantages beyond favorable economics. It gives investors a front-row seat to a GP’s due diligence and post-investment processes. This unique view into how sponsors assess, structure, manage, and optimize value in their investments helps LPs build their own investment expertise.
Working closely with GPs on co-investments can build stronger relationships. This becomes particularly valuable for LPs who want to ensure access to top-tier GPs with potentially oversubscribed funds.
LPs can be more selective with co-investments by choosing opportunities that match their investment criteria. This selective approach lets investors build portfolios around their highest-conviction themes while achieving broader diversification across GPs, market segments, industries, and regions.
Risks of adverse selection and limited control
What is co-investment in private equity comes with notable challenges despite its advantages. One major concern revolves around adverse selection—the “lemons problem” where GPs might offer lower-quality deals to co-investors while keeping better opportunities for their funds.
Extensive research has found little evidence supporting this theory. A 2019 study analyzing 1,016 co-investments by 458 LPs found no signs of adverse selection. Adams Street’s experience tracking deal-level performance since 2006 showed no correlation between deals where they received co-investment opportunities and the performance of all deals completed by those GPs.
Governance complexity remains a real concern. Co-investments usually involve taking minority positions with limited control over the investment. Co-investors depend heavily on the GP to manage the investment effectively and direct the exit strategy since they lack the same operational control as fund sponsors. This information gap means co-investors might get limited reporting and have minimal influence over strategic decisions.
Co-investments can also create concentration risk. LPs might unknowingly develop too much sector or company-specific exposure by investing larger amounts in individual companies, especially when factoring in their indirect exposure through the corresponding fund position.
Step 3: Build a Co-Investment Policy and Allocation Strategy
Creating a reliable co investment private equity strategy needs clear guidelines about allocation, sizing, and how it lines up with your broader investment approach. A well-laid-out policy will give you quick response time to chances while you retain control of your portfolio.
Setting a strategic vs tactical allocation
You must decide between adopting a strategic or tactical approach to private equity co-investments. A strategic allocation sets aside a specific percentage of your portfolio just for co-investments – usually 15% to 30% of total private investments. This lets you take part consistently through market cycles.
A tactical allocation lets you chase co-investments during specific market conditions. This approach often leads to spotty participation or no co-investing.
Strategic allocation builds systematic expertise and relationships. Tactical allocation might make you miss good chances despite your best intentions. Most investors get the best results from a strategic approach with some tactical flexibility.
Sizing individual co-investments appropriately
The right size for each private equity co-investment prevents putting too many eggs in one basket or having too little exposure. Expert advice suggests starting with about 25% of what you’d typically commit to a fund. This amount makes success meaningful but limits damage from poor performance.
You should pace yourself steadily instead of rushing to fill quotas. Setting deployment ranges gives you flexibility while keeping discipline. This balanced method helps avoid time pressure and long periods of unused capital.
Aligning with overall private equity exposure
Investors who have hit their target private investment allocation need smart adjustments to add co-investment fund strategies. One good way is to reduce commitment amounts for fund re-ups to make room for co-investments. This keeps your total exposure steady while adding potentially higher-returning direct investments.
Your co-investment strategy has three main options:
- Develop in-house expertise to get direct control but need substantial resources
- Set up a mandate/joint venture with an experienced private equity firm for balanced control and expertise
- Invest through a dedicated co-investment fund to get professional management with less direct control
Let your GPs know your co-investment strategy clearly. Being open about your goals, abilities, and how you make decisions builds trust and gets you better chances. GPs share dealflow as something valuable, mostly without fees or at low fees, and that deserves respect and professional involvement.
Step 4: Choose the Right Implementation Approach
Your choice of implementation method for co investment private equity strategy will determine how much control you have, what resources you need, and what returns you can expect. This becomes your next big decision after you develop your strategy.
Direct investment vs co-investment fund
Private equity co-investments present two main paths – direct participation or fund structures. Direct investing lets you own specific companies without middlemen. You get more control and higher returns because there are no extra fees. This approach needs strong internal teams to find, assess and track investments.
A dedicated co-investment fund brings its own set of benefits. These funds employ investment teams that focus only on co-investing and have proven track records. The best part is that these funds have strong ties with many lead GPs. This gives you access to more opportunities and lets you be more selective. While these funds charge management fees and carried interest, they still cost less than traditional private equity funds.
Working with co-investment managers
You have several partnership options beyond just using a fund. Joint ventures with co-investment managers let you use their expertise while you retain control. These managers look at opportunities from your existing GP relationships and act as your deal team.
Separately managed accounts (SMAs) help you arrange co-investments with your broader investment strategy. An SMA lets you set specific goals for how fast you deploy capital, what returns you expect, and what risks you’ll take. Meanwhile, an external team manages the whole process.
Considerations for small vs large LPs
The size of your portfolio plays a big role in choosing your approach. Large investors (over $1 billion NAV) easily find opportunities because GPs actively seek them out. Their biggest challenge is having enough resources to assess deals properly.
Smaller LPs with portfolios under $200 million NAV find it harder to get enough co-investment deals. For these investors, combined co-investment funds often work best. These funds provide access to sector experts and middle-market deals.
Mid-sized portfolios ($200 million to $1 billion) sit in the middle. They can find some direct opportunities but also benefit from working with specialist managers. This helps them increase their deal flow with pre-vetted opportunities.
Step 5: Execute, Monitor, and Optimize Your Co-Investment Program
A successful execution is the crucial final phase of your co investment private equity trip. Your returns depend on how well you execute and monitor after setting your strategy and choosing how to implement it.
Due diligence and deal evaluation best practices
Private equity co-investments need a disciplined approach to due diligence. Your first step should be reviewing the GP’s investment committee materials, financial models, and third-party reports (commercial, financial, legal, IT, environmental, and Quality of Earnings). The next step involves focused diligence sessions with the GP to understand their investment thesis and value creation plan.
A proper deal evaluation needs you to get into the GP’s co-investment track record and check if the chance fits their stated “strike zone”. You should stress-test financial model assumptions and make reference calls before making your final decision.
The “do every deal approach” dilutes overall returns and limits tactical portfolio construction, which increases adverse selection risk. This approach might lead you to double down on exposures you already have through fund commitments.
Ongoing monitoring and reporting expectations
Co-investment fund positions need more active monitoring than traditional fund investments. Quarterly valuations, financial statement reviews, board presentations, and potential follow-on investment needs should be part of your routine.
Of course, GPs vary greatly in how much due diligence information and ongoing monitoring they provide. You should avoid co-investing with GPs who won’t provide enough due diligence materials or quarterly reporting beyond simple capital statements.
Avoiding common pitfalls and maintaining GP relationships
A major pitfall in direct investment private equity is backing out at the last minute. GPs prefer a quick “no” over a slow withdrawal. You should communicate your co-investment process to GPs and stay transparent throughout to ensure everyone has a positive experience.
Strong GP relationships come from professional handling of co-investments. Quick responses and transparency are essential – give feedback within 48 hours, share key questions early, and explain quickly if you’re declining. More importantly, deliver on your promises: if you set a closing date, stick to it.
Don’t reject investment opportunities just because a GP charges some economics. While “free lunch” sounds appealing, it makes sense to pay reasonable fees to access outperformance, as long as they stay below traditional fund commitments.
Conclusion
Mastering Co-Investment: Your Path to Improved Private Equity Returns
Private equity co-investment stands out as a compelling alternative to traditional fund commitments. In this piece, you’ve seen how this approach delivers substantially higher returns—27.1% IRR compared to 18.9% for traditional investments. You’ll also gain better control over your investment exposure.
Success in co-investing starts with a solid grasp of basic structures through syndication or co-underwriting opportunities. The lower fee structure is the most attractive benefit. High-quality deals and stronger GP relationships add great value too.
Your investment strategy needs a well-planned allocation approach instead of just reacting to opportunities. Top investors put 15-30% of their private investment portfolio into co-investments. They size individual deals carefully to balance risk with meaningful exposure.
Your choice of implementation—direct investments, co-investment funds, or hybrid approaches—should line up with your portfolio’s size and internal capabilities. Fund structures work better for smaller LPs. Larger investors can build internal teams for direct participation.
Disciplined execution will determine your results. The most successful co-investors stand out through rigorous due diligence, consistent monitoring, and professional GP engagement.
Co-investments in your strategy need both commitment and expertise. The performance advantage makes this effort worthwhile, but proper preparation remains key.
Want to see how private equity co-investments could improve your investment portfolio? Book a strategy call with Primior at https://primior.com/start/. Our experienced team will guide you through this lucrative investment approach with confidence.
