At first glance, the key driver behind this trend appears to be risk-sharing, but the recent Pepper Hamilton LLP / Mergermarket Study provides a more telling look at why co-investments are on the rise.
by Bruce K. Fenton
The hottest trend among private equity groups is co-investment. Private equity firms are increasingly seeking to involve other investors in their deals, and contributions from co-investors are becoming more significant portions of the funding for acquisitions. A recent study sponsored by Pepper Hamilton LLP in association with Mergermarket, “Joining Forces: The Co-Investment Climate in Private Equity,” investigated these trends and found that 100 percent of surveyed funds offer co-investment opportunities. A majority of general partner respondents also said they were actively exploring investment opportunities that would enable their funds to offer occasions to co-invest.
At first glance, the key driver of this trend appears to be risk-sharing, a common rationale when pooling capital. Indeed, 26 percent of private equity firms cited this as the primary reason for the increase in co-investments. A closer analysis, however, provides a more telling look at why co-investments are on the rise. Other driving forces—and the percentage of respondents who named them—include:
These key drivers provide insight into current developments in the private equity space, as well as the primary benefits of co-investment. As investors decrease the number of funds they invest in, fundraising concerns have become more important to private equity firms. Even when not actively raising capital, they must focus continuously on fundraising. One way they do this is by offering co-investment opportunities, which can directly facilitate the fundraising process and indirectly help by establishing relationships with new potential investors.
Co-investment allows private equity firms and investors to establish a history of investing together, which the private equity firms can capitalize on later by offering a co-investor the chance to invest in the firm’s next fund. Private equity firms can also use co-investments to facilitate differentiation and specialization, and to capture high-quality partners, particularly in the private equity firm’s key industries.
Despite these benefits, co-investment relationships are complex, and private equity firms and investors face regulatory hurdles. In the Pepper/Mergermarket survey, 76 percent of respondents cited regulatory scrutiny as one of the biggest challenges to co-investment.
There are some potentially costly regulation-related concerns for co-investments. Co-investment vehicles are required to maintain separate books and records and undergo an annual audit, and they may be subject to U.S. Securities and Exchange Commission examination. They are also subject to scrutiny around fiduciary dutyand disclosure-related concerns. For example, offering to waive the management fee or carried interest for the co-investment opportunity may raise concerns, and certain transaction fee and expense terms must be properly examined for conflicts of interest so as not to invoke regulatory scrutiny.
To overcome these challenges, private equity firms must focus on providing enhanced disclosures during the fundraising process and developing policies and procedures that reflect industry best practices. By insulating themselves from liability in this environment of enhanced regulatory scrutiny, they will be able to maximize their competitiveness by continuing to offer co-investment opportunities.