Making Sense of the Direct and Co-Investment Landscape
As direct and co-investments have gained in popularity among family office and institutional investors, investment firms have responded by offering a variety of options to meet this demand. But not all direct or co-investment opportunities are the same, and the challenges and pitfalls they present to an investor vary depending on the different pipes that source the deal. This piece considers the various sources for direct and co-investments to better understand the pros and cons of each so that investors – particularly family offices and small to mid-size institutional investors who often lack access to the best deals or sufficient resources to evaluate them – can better navigate this increasing complex and crowded landscape.
Private Equity Funds
Private equity firms are a significant source of co-investment options, offering their LPs co-investment opportunities in cases where they are unable to fund an entire investment through their fund. As I have written elsewhere, while these deals are typically offered on a no fee/no carry basis, they often come at a substantial cost and can be difficult to access, particularly for smaller LPs such as small to mid-size institutions and family offices.
· Pros: Established private equity firms typically offer large, credentialed teams that bring sector expertise and play an active role in their investments. Their committed capital enables them to act quickly in competitive processes, and they are a plentiful source of co-investment opportunities. These deals tend to be large in size and are offered to LPs on a no fee/no carry basis.
· Cons: There are a number of subtleties to co-investing in PE deals that can disadvantage the family office or small to mid-size institutional investor. Fee structures can be opaque with hidden costs along the way, such as monitoring fees; PE firms may get paid by the portfolio company, as well, creating a potential misalignment of interests; an investor must make a sizeable commitment to the PE fund that is locked-up, usually for a 10-year period; investors in funds are at the mercy of the GP managing the fund -- you don’t get to pick and choose which deals the fund invests in; co-investment opportunities are typically shown to the largest investors first, as PE firms prefer to deal with the largest and most sophisticated LPs that can act quickly; finally, co-investments offered by funds are known to under-perform the private equity funds which suggest adverse selection.
· Fees: While co-investments are offered on a no fee/no carry basis, investors must invest in the underlying PE fund where there is generally a 2% management fee and a 20% carried interest plus a host of other hidden fees throughout the transaction.
PE Fund of Funds / Co-Investment Funds
Another way to access co-investments is by investing in a blind pool fund that in turn invests in co-investments sourced from private equity firms and independent sponsors. Many large asset management firms and private equity fund of funds have sizeable commitments to a diverse portfolio of private equity funds. As a result of these large fund commitments, they are given preferred access to co-investment opportunities from their private equity funds because of their ability to execute quickly and efficiently. These asset management and PE fund of funds raise a separate pool of committed capital to invest in these opportunities known as a co-investment fund. From time to time, these co-investment funds may also offer their LPs co-investment opportunities that are too large for their fund.
· Pros: These firms tend to gain access to some of the better co-investment deal flow from private equity funds. They have experienced teams to screen and diligence individual co-investment opportunities and these are known to be cheaper than investing in a private equity fund.
· Cons: Co-investment funds may suffer from the adverse selection bias that have plagued co-investments offered by private equity firms when compared to their funds. These deals tend to be the very large transactions which, because of their size, tend to have less compelling risk/return potential than smaller deals. These funds are incentivized to allocate as much capital as possible to keep their GP relationships happy. Additionally, LPs in co-investment funds must invest in a blind pool and are at the whim of the discretion of the manager.
· Fees: 1.5% management fee plus 15% carry. There may be hidden fees throughout the value chain i.e. monitoring fees, origination fees, transaction fees etc.
Placement agents are third party marketing firms that assist companies and private equity firms to raise capital for funds in addition to individual deals. Certain placement agents are known to be selective on the clients they take on, but many can be unscrupulous.
· Pros: There are good placement agents out there that are highly selective regarding the mandates they take on since their reputation is on the line. As a result, their deals are typically worth evaluating. In addition, they don’t charge investors so there is no fee disadvantage to evaluating their opportunities other than time. That being said, some have better reputations than others, and investors should consider this before proceeding.
· Cons: Because placement agents effectively act as a broker, all they do is act as a source of investment. They do not provide any additional value to an investor in a deal – no deal curation, no due diligence, no investment advisory functions. In fact, they represent the company/GP, not the investor, and their only aim is to raise money for an opportunity.
· Fees: No charge to investors. They get paid by the issuers which could be ~5% of proceeds raised for a deal or 20% of the asset management fees.
Merchant banks merge investment banking, corporate advisory, principal investing, and asset management. They work directly with companies and make principal investments while also raising third party capital. They also bring value to the company by advising the company on corporate matters. Finally, a new trend has emerged whereby merchant banks create special purpose vehicles (“SPVs”) as a single point of entry into the company by outside investors. They typically take carry on these vehicles.
· Pros: Merchant banks can be a compelling source of direct deal flow and usually have extensive expertise in a particular sector and add value through their advisory work with the companies they work with. In addition, they invest their own capital in the deal.
· Cons: It is difficult to ascertain if the investor’s interests are aligned with the merchant bank. Merchant banks typically charge origination fees to companies, advisory fees for their on-going work, and finally charge investors carry for monies that come through the SPV they manage. It is unclear if they are working for the company or for the investor creating an alignment of interest problem nonetheless. They get paid as an investment manager but also get paid by the issuer for originating the deal.
· Fees: They are typically paid by the issuers approximately ~5% of the proceeds raised, may collect advisory fees on an ongoing basis from the company, and finally ~20% of carry paid by investors for the SPV they manage.
Independents sponsors are typically small private equity firms that do not have a committed fund. They source, underwrite, and manage transactions, but must raise capital separately for each deal.
· Pros: Independent sponsors are a good source of curated deals and tend to have specialized expertise. Investors also have the option to choose which deals in which they participate.
· Cons: Independent sponsors tend to be less institutional, have difficulty participating in competitive transactions because they lack committed capital, and while some are very good, it’s difficult to know which ones are reputable. Additionally, they may overpay to win transactions since the counterparty knows they lack committed capital. They may need to be creative to get companies to deal with them.
· Fees: Fees usually range from 1 and 20 to 2 and 20, but can be less. Independent sponsors may also collect origination, transaction, advisory, and monitoring fees as well.
Boutique banks tend to be smaller investment banks that usually have a geographic or sector expertise. They are engaged by companies to raise capital from third parties.
· Pros: Boutique banks are a good source of direct deal flow which is why most private equity firms rely on them.
· Cons: The flip side of the steady deal flow is that the quality of the deals can vary greatly. And while the banks may bring regional or sector expertise, they often do not have much quality control. From a fee perspective, because they only make their money from deal fees, their only interest is to get the deal done, which creates a misalignment of incentives with investors. Their deals are direct, so there is no investor due diligence or professional management attached to the transaction.
· Fees: ~5% paid by the issuer.
Given the wide variety of sources for direct and co-investment deals and their different advantages and disadvantages, it can be hard for an investor to know how to proceed. To simplify things, most of these variables fall into three buckets:
1. Deal Quality/Sponsor Quality: Is this a good deal? Why is it coming to me? Who is the sponsor? How did they get the deal? What type of due diligence and underwriting was conducted? Is the sponsor bringing value to the transaction? What type of track record does the sponsor have in these types of deals?
2. Alignment of Interest: Who pays the fees? What are the fees throughout the value chain of a transaction? Are interests aligned? Do the investment parties have skin in the game? Are fees paid by the issuer or the investor? Are they paid on both ends?
3. Good Governance: What are the investment processes like of the deal lead? Are they screening investments? Do they bring institutional quality governance practices, including strong due diligence capabilities? How is the deal lead configured – are they an RIA (registered investment advisor)? A broker dealer? Do they add value to the transaction itself or are they just charging for access?
Building a network across all of these channels is a resource challenged endeavor, but there are some new, sophisticated market entrants that are dis-intermediating the investment landscape, particularly in the investment advisory / independent sponsor RIA sector, and that are able to offer many of the best aspects of these various deal sources without the disadvantages. These types of advisors are sourcing their transactions from a variety of independent sponsors – acting as a sort of “meta” independent sponsor -- while also providing a full suite of advisory services, institutional quality managers and deal infrastructure, along with competitive fee structures that are aligned with investor interests.
So while many of the options discussed in this piece may be good sources of deals, as we’ve seen, most disadvantage the family office or smaller institutional investor and raise questions about deal quality, fees, conflicts of interest or institutional caliber. Some of the options from the newer market entrants may be better able to help family offices and smaller to mid-size investors gain access to more compelling co-investment opportunities.