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Chapter 9
Co-investments in funds of funds and separate accounts
By Brian Gallagher, Twin Bridge Capital Partners
BACKGROUND
While co-investing has been an important part of
private equity investing for many years, it has recently become much more prevalent and an important
area of focus for institutional and fund of funds
investors. Undoubtedly, investors have come to
realise that there are significant quantitative and
qualitative benefits to co-investing. Like much of private equity, co-investing has become much more
competitive and allocations to the best deals are coveted. These trends will likely persist into the foreseeable future.
Co-investing can be done in all areas of alternative
investments including hedge funds, venture capital,
mezzanine and buyout investments. Equity coinvestment in buyout deals is the largest and most
recognised segment and the focus of this discussion.
The concepts and examples illustrated here, however, can be applied to any type of co-investment,
regardless of whether the co-investments are done
through a fund of funds vehicle or an institutional
separate account.
HISTORY OF CO-INVESTMENT
Co-investment has been around for nearly as long as
the buyout industry itself. The practice became
mainstream during the mid to late 1990s, as institutional investors sought additional ways to deploy
capital and general partners (GPs) began to see limited partners (LPs) as helpful in executing larger
transactions. Initially, it was common for equity
sponsors to charge a reduced carried interest on coinvestments. As the co-investment industry
matured, GPs began to view co-investment investors
as true partners. Deals were increasingly done with
no management fee and no carried interest.
CURRENT STATE OF CO-INVESTMENT
Co-investing is now a mainstream and accepted
component of today’s private equity industry.
During fundraising, GPs are routinely asked by interested LPs to address the likelihood of co-investment
in their next fund. While some GPs look at co-investment as a requirement to entice certain LPs into a
fund commitment, the practice has evolved into an
important part of the business model for most equity sponsors, offering a wide range of benefits to both
the LP and the sponsor. It is important to note that
while many LPs clamour for co-investment opportunities, a significant percentage of these LPs do not
have the staffing or infrastructure to respond to and
commit to co-investment opportunities in a timely
manner. LPs who effectively structure their organisations to execute on a co-investment programme
find themselves at a competitive advantage for
access to these benefits.
THE BENEFITS OF CO-INVESTING TO THE LP
Quantitative benefits
Substantial quantitative benefits accrue to co-investing LPs. These benefits are attributable to the positive cash flow characteristics associated with today’s
co-investment deals, including improved net return
and accelerated capital deployment. Because coinvesting is done either free of management fee and
carried interest, or at substantially reduced rates,
the LP will, by definition, improve its net investment
returns relative to a programme that invests exclusively in funds. The improvement in net returns for
an active co-investor can be as much as 300 basis
points or more as compared to a standard fund
investing programme. By actively co-investing, an LP
can deploy capital with quality sponsors at an accel-
While co-investing has been an
important part of private equity
investing for many years, it has recently
become much more prevalent and an
important area of focus for institutional
and fund of funds investors.
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In addition to the superior quantitative
benefits for an LP, the qualitative
characteristics associated with
co-investing yield ongoing returns to the
relationship between the LP and the
equity sponsor.
erated rate, which reduces the J-curve effect associated with its private equity investing. A thoughtful
and well-constructed co-investment portfolio can
also allow the institutional investor to further diversify its portfolio and increase exposure to sectors
that the co-investor prefers.
For many active co-investing LPs, co-investments
typically comprise 25 percent or more of their overall private equity exposure. Clearly, the quantitative
benefits experienced by the LP depend on the size of
its co-investment portfolio. Exhibit 9.1 highlights
the primary quantitative benefits associated with a
significant co-investment programme.
Qualitative benefits
In addition to the superior quantitative benefits for
an LP, the qualitative characteristics associated with
co-investing yield ongoing returns to the relationship between the LP and the equity sponsor. Coinvestments allow the investor to develop close
relationships with senior equity sponsor professionals. This allows the investor to obtain a firsthand
understanding in how the sponsor executes the deal
process and to obtain better insight into the sponsor’s capabilities and operating style.
Co-investments normally involve countless hours
spent with senior sponsors in the course of underwriting and management of a co-investment. This is
invaluable time that helps to develop strong relationships and mutual trust. The co-investment
process is also an ideal time for investors to better
understand how the sponsor structures and sources
its deals, performs due diligence, manages the
investment, works with company management, executes on their plan and exits the investment. In addition to an increased level of comfort, this
understanding helps the investor to identify the
strengths and weaknesses of their sponsor and to
make decisions accordingly. A better understanding
of the capabilities of the sponsor may lead an
investor to significantly increase its commitment to
the sponsor’s next fund. Conversely, an unsuccessful
co-investment experience may lead an investor to
reduce its investment or not invest at all in the equity sponsor’s next fund. The net result is that coinvestment experiences help LPs make better
informed decisions with regard to their GP relationships and fund investments.
BENEFITS TO THE EQUITY SPONSOR
The benefits of co-investing are not restricted to the
LP. In fact, co-investments generate several meaningful benefits for the equity sponsor. Foremost
among these benefits is the ability for the sponsor to
Exhibit 9.1: Sample net cash flow by year – traditional funds of funds vs funds of funds with co-investment
120
100
80
Funds of funds
Funds of funds with co-investment
$ millions
60
40
20
0
-20
Co-investment drives
improved net cash flow
and capital deployment
-40
-60
-80
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14
Source: Twin Bridge Capital Partners.
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CO-INVESTMENTS IN FUNDS OF FUNDS AND SEPARATE ACCOUNTS
Exhibit 9.2: The co-investment process
Sourcing
Due diligence
do larger deals than its funds may otherwise support, while retaining control over the investment
necessary to ensure success. The alternative for the
equity sponsor is to pursue a joint investment with
another sponsor, which can lead to difficult governance provisions and a decreased ability to effectively control operating decisions.
Additional sponsor benefits to co-investment
include an expanded LP market, closer LP relationships and the benefit of unique viewpoints brought
by the co-investor. Because co-investing has become
such a pervasive part of private equity and desired
by so many LPs, an equity sponsor that embraces coinvestment can expand its universe of desirable LPs.
Like the co-investor, the sponsor also develops a
closer relationship with LPs through co-investing.
Finally, a knowledgeable and experienced coinvestor brings a unique viewpoint to the transaction and can add insight, relevant advice and a
network of resources that can all serve to improve
the outcome of the investment. As with the LP,
these benefits are realised through careful management by the equity sponsor throughout the coinvestment process.
As with any investment, becoming part of
the process is crucial to becoming part of the benefits. The next section describes how LPs and GPs
work together to manage the co-investment
process effectively.
THE CO-INVESTMENT PROCESS
Every co-investor will have differences in how they
source, underwrite and manage co-investments.
There are, however, many common features associated with the construction of a successful co-investment portfolio. The simplest approach to describe
co-investing and its corresponding benefits, is to
step through the process of completing a co-investment transaction (see Exhibit 9.2), including sourcing, due diligence, management of the deal and
ultimately investment realisation.
Key terms and
governance
Post closing
Sourcing
Because sourcing for co-investments typically comes
from existing fund commitments, it is important for
the co-investor to express a strong desire for coinvestments both at the time of the fund commitment and through periodic follow up calls and
meetings. Just as equity sponsors call on intermediaries to generate deal flow, potential co-investors
must be diligent in routinely conferring with their
fund relationships regarding their ability to participate in potential co-investment opportunities.
The sponsor wants a co-investment partner who can
respond quickly to the opportunity and can meet the
timeline needed to close the deal. In recent years, the
timeline to win and close a deal has become very
compressed. This trend is unlikely to abate any time
soon. Typically, a sponsor will send to potential coinvestors summary material that describes the transaction and the investment thesis to be carried out by
the sponsor. Each co-investment institution will have
its own process and procedures for determining
interest in an investment. Co-investors differentiate
themselves by responding to these opportunities as
quickly as possible, even if there is no interest in the
transaction. Equity sponsors will often state that a
potential co-investor who quickly turns down a deal
is much preferred to one that takes weeks to conclude on whether or not it is interested.
Due diligence
Once a co-investor has decided to move forward
with a transaction, the due diligence phase commences. This phase can be lengthy and involve voluminous amounts of material. Fortunately for the
The sponsor wants a co-investment
partner who can respond quickly to the
opportunity and can meet the timeline
needed to close the deal. In recent years,
the timeline to win and close a deal has
become very compressed.
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Key terms and governance
While the process of committing to
a co-investment may take weeks or
months, equity sponsors prefer that
the co-investment partner moves
through the process in real time
alongside the sponsor.
co-investor, the core due diligence on the transaction should have been led by a capable equity sponsor and the co-investor should be able to rely on this
work. The co-investor often elects to perform supplemental due diligence to improve its evaluation of
the investment. Additional resources and relationships that may not be available to the equity sponsor
are frequently called upon to provide advice,
appraisals, and general information. The result is
diligence that is highly reliable and thorough.
Every transaction is somewhat different in the due
diligence materials needed and produced. Typical
items include:
•
•
•
•
•
market analysis;
detailed financial modelling;
meetings with company management;
third-party diligence review;
identification and understanding of the risks
and their potential mitigants; and
• identification of growth opportunities and
exit options.
By the time a co-investor has been contacted by the
sponsor about an opportunity, it is common that
some of the information outlined above has been
completed, but not all of it. The co-investor will
review the initial and ongoing information with the
sponsor as the due diligence material is completed.
This process can take as little as weeks, but more
typically is completed over two to three months.
After the completion of all due diligence, each coinvestor needs to formally commit to the co-investment. This commitment is subject to that
institution’s underwriting and investment committee requirements. While the process of committing
to a co-investment may take weeks or months, equity sponsors prefer that the co-investment partner
moves through the process in real time alongside
the sponsor.
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After formal commitment to a co-investment, the
final step before funding is the completion of all of
the legal documents. These include documents used
to acquire the subject company, as well as the documents governing the terms between the equity sponsor and co-investor(s). The legal documents used to
acquire the company include the purchase agreement, debt documents and employment agreements. The co-investor will typically review these
documents to ensure that they understand the terms
of the investment, but will generally have very few
comments given that these documents were prepared by a capable equity sponsor and their legal
counsel. In effect, legal documentation that raises a
number of substantive issues become a due diligence
question as opposed to a legal question.
The documents governing the agreement between
the sponsor and the co-investor should of course be
reviewed in detail by the co-investor, with experienced legal representation. Often, these terms will
be documented in a limited liability company agreement that includes all of the equity investors as signatories. In this agreement, there are several key
terms that the co-investor will want to consider, particularly in an effort to remain aligned with the equity sponsor. These terms include:
• Pre-emptive rights. If the equity sponsor puts in new
equity on any terms, the co-investor will want the
right to invest its prorated share in the same deal.
• Tag-along rights. If the equity sponsor exits any or
all of its investment, the co-investor will want to be
able to tag along in the sale for its prorated amount.
• Registration rights. If the exit for the investment is
a public offering, the co-investor will want to be
able to register and sell its shares alongside the
equity sponsor.
• Information rights. The co-investor will want
access to at least quarterly financial information
on the performance of the company.
Depending on the size of the co-investor’s investment, a board seat or board observer seat may be
warranted. Typically, if a co-investor has 20 percent
or more of the equity in a deal, the co-investor
should expect a seat on the company’s board; if a coinvestor has 10 to 20 percent of the equity, a board
observer seat is more typical; below 10 percent of
the equity, the co-investor will typically not attend
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board meetings and will rely on its financial information rights to remain informed. Proper structuring with regard to each of the rights outlined above
is important for the co-investors to feel aligned with
the equity sponsor.
Post closing
The role of a co-investor after closing the transaction is significantly different from the role of the
sponsor. The equity sponsor will spend considerable
time managing the investment and conferring with
management regarding operating issues, acquisition opportunities and other items. The co-investor
will monitor the investment’s performance closely,
either directly through board participation or periodic discussions with the sponsor. Depending on
the nature of the investment, there may be a need
for additional equity to execute acquisitions. In
these cases, the role of the co-investor is more
important and the time spent monitoring the deal
will be more considerable.
MYTHS ABOUT CO-INVESTING
While the benefits associated with co-investing are
significant and the process fairly straightforward,
confusion persists within parts of the institutional
investor community with regard to downsides associated with co-investing. These “myths” include
adverse deal selection concerns, rights afforded to
co-investors as part of their transactions and underestimation of the effort required to execute a successful co-investment programme.
Some institutional investors believe that co-investing leads to adverse deal selection. Their concern is
rooted in a belief that equity sponsors will only show
their worst deals to co-investors and keep the most
promising deals for themselves. This belief runs
counter to the experience of most co-investors and
does not pass the reasonableness test for a number
of reasons. First, equity sponsors do deals they think
will perform well and will meet return hurdles.
Sponsors, however, do not have prescient knowledge of which deals will work perfectly and which
will not. Second, and perhaps more importantly,
equity sponsors value and need their LP relationships and therefore strive to ensure that co-investment LPs are satisfied with the sponsor’s
performance. It is not in the best interests of any
party, therefore, to present a substandard deal to a
potential co-investor and place an important relationship at risk.
Another myth exists with regard to a potential coinvestor’s rights in a transaction. Some perceive the
co-investor as a marginalised player in deals. The
reality is that a fine line exists between a co-investor
allowing the sponsor the freedom to execute on its
plan and the co-investor ensuring that their interests are protected to the extent possible.
Sophisticated co-investors, however, often have the
ability to manage this line through active involvement in the deal process and by continuing to participate post close. These investors will determine
which minority rights are critical to ensuring a satisfactory outcome. They may also supplement the
point of view they bring through board or observer
seats, and may be critical in helping finance the
future needs of the company. These opportunities
allow the co-investor the proper rights to actively
manage their investment.
Arguably the most common myth seen today is that
co-investing is a simple business and an easy extension to fund investing activities. This is incorrect.
While the co-investment process is straightforward,
it requires careful management to be successful.
Like other investment disciplines, there is an art and
science to managing a co-investment programme
and the skills needed are developed through years
of experience.
Some of the parties described above see their coinvestment role as passive, including participation in
all deals presented by their fund relationship. The
history of the buyout industry reflects countless
institutions that underestimated the time and effort
that goes into building and maintaining a successful
co-investment programme. As a result, there are a
finite number of institutions today that are well
known and well regarded as outstanding co-investment partners. These partners spend significant
While the benefits associated with
co-investing are significant and the
process fairly straightforward, confusion
persists within parts of the institutional
investor community with regard to
downsides associated with co-investing.
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Many factors determine success in
co-investing. First and foremost is
experience. A co-investor who has invested
in many deals over numerous business cycles
develops invaluable experience and insight
into what deals will work and which will not.
time making independent decisions and participating heavily in the co-investment process. The most
successful of these institutions continue to see
through the myths today and remain diligent about
the selection of their partners and independent
about their decisions.
SUCCESS FACTORS IN CO-INVESTING
Many factors determine success in co-investing.
First and foremost is experience. A co-investor who
has invested in many deals over numerous business
cycles develops invaluable experience and insight
into what deals will work and which will not.
Quantity and quality of co-investment deal flow is a
function of the reputation and experience of the coinvestor. Nothing is more important to an equity
sponsor than a co-investor with experience, a stellar
reputation, an ability to commit quickly to a potential deal and to stick with the diligence alongside
the equity sponsor until the deal closes. It should
also be noted that a co-investor builds its reputation
by being a supportive partner in good times and
bad. There will be circumstances in which a deal
does not perform, necessitating corrective action
and additional equity. It is in these situations where
an experienced and responsive co-investor can distinguish itself.
Successful co-investors must also take an objective
and dispassionate view of each opportunity presented. Equity sponsors can become enamoured with a
company or management team. A good co-investor
will try to discern if the investment strategy and the
skills of the sponsor warrant an investment.
Experienced co-investors will often do only a fraction of the investments offered, so selectivity is an
important factor to be considered. Turning down a
co-investment that a sponsor believes strongly in is a
delicate process that can test the strength of the fund
relationship.
THE FUTURE OF CO-INVESTING
Co-investing will persist as an important and growing
segment of the private equity industry into the foreseeable future, with both LPs and equity sponsors
continuing to seek the benefits afforded by the coinvesting relationship. While some recent activity
shows equity partners partnering on investments to
the exclusion of co-investors, the difficulties in governance and increased scrutiny of regulators make
these arrangements tenuous. As a result, traditional
co-investment LPs will play an increasingly important
role in helping sponsors complete future investments.
As institutions continue to add co-investing to their list
of investment activities, however, the search for topperforming co-investment partners will become
increasingly competitive. Just as traditional fund
investors relentlessly pursue first quartile fund investments, expectations for co-investments will be similar.
The ability to achieve superior co-investment results
will continue to be defined by those institutions that
align with experienced and proven professionals executing on a proactive and thoughtful programme.
Brian Gallagher is a managing partner of Twin Bridge Capital Partners (Twin Bridge). Based in Chicago, Twin Bridge focuses on investing
in middle-market buyout funds and co-investments in North America. Twin Bridge currently manages over $500 million in separate
accounts. Mr Gallagher has spent most of his career in the middle-market buyout industry, having previously worked at UIB Capital, PPM
America and Arthur Andersen. He received his MBA at Northwestern University’s Kellogg Graduate School of Management, and a BA in
accounting from the University of Notre Dame. He holds the chartered financial analyst designation and is a certified public accountant.
Mr Gallagher is a member of the CFA Institute and AICPA.
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