Are Free Co-Investments Really Free?
With public markets becoming increasingly expensive, family offices and institutional investors are turning to the private markets to meet their risk/return targets. While private equity funds have historically been the venue to access private markets for traditional LPs, there has been a desire to bypass the funds and go direct. As discussed in a recent Bloomberg article, investors have started to build out the capability to evaluate direct and co-investment opportunities, but most still prefer to participate in opportunities originated by their current GPs and given to them typically on a no fee no carry basis. In turn, PE firms use co-investment opportunities as a carrot to raise capital for their committed funds.
Co-investments have become an incredibly sought after opportunity with an entire cottage industry built around them but are co-investments really “free”? Put another way, are the benefits of some co-investments outweighed by the drawbacks, and are there better alternatives for traditional LPs?
Free co-investment deals sound great in theory: an LP gets to invest in a direct deal underwritten by a top tier GP without paying the standard private equity fees, retains the ability to determine their precise capital deployment, and sees mitigation in the j curve. The trouble for most smaller and mid-size LP investors, say investors that are looking to write checks in the range of $5m-$25m, is that the reality is far less sanguine. Here’s why:
1. Most LPs will never get to see the best co-investment deals – LPs typically only get to co-invest if a deal is so big that a fund decides not to fund the entire deal itself. So right off the bat co-investment opportunities in the context of private equity inherently means that someone has already passed on the deal. In fact, there is an entire investment food chain fighting for co-investment opportunities with the biggest ones 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.
2. “Free” co-invest deals can actually be quite costly – This last point is perhaps the most surprising. Even though an LP doesn’t have to pay for the co-invest in a particular deal, there are many fees along the way that dim the appeal of these opportunities. Monitoring fees, which can be accelerated by PE firms, are a particularly insidious and costly example of fees that LPs are on the hook for, even in a free co-invest scenario. Private equity firms charge their portfolio companies monitoring fees that can cost the company millions of dollars each year. GPs have come under increasing scrutiny by the SEC for fee abuses and fraudulent practices related to monitoring fees, among other practices, and have successfully litigated such cases against some of the bigger PE players.
In fact, LPs are distinctly disadvantaged by an overall lack of fee transparency. According to the Center for Economic and Policy Research, private equity GPs have repeatedly misallocated PE firm expenses and inappropriately charged them to investors; have failed to share income from portfolio company monitoring fees with their investors, as stipulated; have waived their fiduciary responsibility to pension funds and other LPs; have manipulated the value of companies in their fund’s portfolio; and have collected transaction fees from portfolio companies without registering as broker-dealers as required by law.
An LP therefore needs to consider all of these ancillary fees and the related pervasive, abusive tactics when evaluating the cost of a “free” co-invest opportunity.
3. Most LPs don’t have the infrastructure to co-invest – In addition to these costs, many LPs simply don’t have the infrastructure to take advantage of co-investment opportunities because they lack the capacity or expertise to screen the opportunities, perform the due diligence, negotiate term sheets, etc. As a result – and as the Bloomberg story reference above pointed out – many of these LPs are having to bolster staffing with analysts who can provide this support, further adding costs to a co-investment process.
Exposing the hidden costs in “free” co-investment
Let’s take an example.
Consider a private equity fund looking to buy an industrial company and raise a portion of the funds in co-investments. Well just for starters, for most transactions there’s a competitive bidding process to win the deal, and bankers take fees right off the top, which could be as much as 7.5% or more. Also add into that transaction fees a fund might take for originating the deal.
Then, in order to have access to the co-investment in the first place, you have to be an LP of a certain size in the private equity fund, which means that you have committed capital to the PE fund on which you are typically paying 2 and 20 fees that is locked up for 10 years.
Finally, as I mentioned earlier, given the pecking order of the food chain, smaller investors will most likely not get to invest as much as they would like (if at all) into one of these opportunities.
So in summary, while the “free” co-investment may overall reduce the 2 and 20 fees you are paying to invest in a private equity fund, the combination of (1) the likelihood that you aren’t seeing the best deals; (2) the cost of your long-term committed capital; and (3) the fact that you probably won’t get to invest as much as what you want strongly suggests that smaller and mid-size LPs are better off looking elsewhere for co-investment deals that can provide the returns they seek.
So how can LP investors find better co-investment opportunities? And how can they overcome the challenges of accessing high quality deals and then executing them?
RueOne Offers a Better Co-Investment Solution
RueOne solves these challenges for investors.
· RueOne Gives Investors Access to Premier, Differentiated Deal Flow without the Need to Commit to a Fund
We provide direct and co-investment opportunities where we either (a) take on what one might think of as a more traditional banking function, originating the deal internally on behalf of a company’s management and appointing a special advisor (rather than a sponsor) or (b) we source from our own extensive proprietary global network of sponsors and asset managers with specific domain expertise and proprietary deal flow. Our network is far larger than what an institutional investor or family office could access and vet on their own. Our investors gain access to our opportunities without any upfront commitment or paying an extra layer of fees.
As a result, RueOne can provide investors opportunities that are typically more compelling than what they are used to seeing in a traditional co-investment structure. Investors who come to us can be certain that they are seeing a differentiated opportunity that hasn’t been shopped around on the street and passed on by a number of investors before being shown to them, and that we are investing in each transaction on a principal basis.
· RueOne Provides the Expertise and Support Investors Need to Screen and Execute Direct Deals
RueOne augments the resources of smaller investment offices with a best-in-class infrastructure to make it easier for them to analyze and transact co-investments. We provide rigorous due diligence and underwriting of every deal we present to our investors that subjects each sponsor and investment opportunity to a thorough due diligence process conducted by our investment team. We provide our internal due diligence in addition to detailed presentations and comprehensive data rooms of materials to help streamline your due diligence process. In addition, we have put in place an institutional quality governance structure around our investment process, which is overseen by the investment subcommittee of our Board comprised of management and independent directors.
Finally, we have assembled an impressive array of experienced investment talent on our advisory board, which we call our Council of Experts. Each member is a highly experienced investment professional with specific domain expertise and brings specific transactional expertise for every deal we present to our investors. As a result, we believe our investors see only the highest quality investment opportunities.
· RueOne offers better co-investment deals at lower cost
At RueOne, we’re doing all of the sourcing ourselves. We offer top quality deals that are exclusive to us, which means that they are more likely to provide the total returns that LPs seek from co-invest opportunities since our deals cut out all of the extraneous fees that make PE investment so costly, hidden and otherwise. They are not bid up in price through auction processes and associated bankers’ fees. There are no brokers or middle men charging fees along the way that end up costing the investor even on the “free” co-invest deals. We provide total fee transparency and your capital isn’t locked up as they are in a traditional PE fund.