Private Equity Co-Investing: Getting More Than What You Paid For
Private equity investing has long been seen by sophisticated investors as a means of generating returns in excess of what is available in the public markets realm. It is well documented that institutions such as Yale’s mammoth endowment fund have used private investments for decades to enhance portfolio performance. Likewise, many of the wealthiest families in the world have made private equity a prominent component of their portfolio mix.
It is not hard to understand these investors’ fascination with private equity. While actual results vary significantly across individual “vintage years,” annual excess returns of 3-5% or more over the life of a private equity fund has not been unusual.*
But What About Those Private Equity Fees?
While private equity investing has often produced attractive results, the fees charged by general partners (“GPs”) can be commensurately high. GPs command high fees for their specialized expertise and the intensive hands-on management that private equity investments require. Most private equity funds adhere to the classic “2 and 20” fee model, that is, a 2% annual management fee plus a 20%-of-profits incentive (a.k.a., the carried interest). As a result of these fees, a fund that generates a 20% gross annual Internal Rate of Return (IRR) over its life will pay roughly 5-6% annualized to its GP. While the resulting net IRR to the investor may still be quite attractive (14-15% in this case), the fee bite is nonetheless enough to give some investors pause. (Note: all returns in the prior table are net of fees).**
Introducing Private Equity Co-Investing
Private equity co-investing is one way large, sophisticated investors have reduced their private equity fee burden. Private equity co-investments can be broadly defined as minority (i.e., non-control) investments in direct private equity deals made available through a fund GP. Co-investors invest alongside (but outside of) the GP’s fund. GPs seek out co-investors when they have identified a relatively large deal that would create an over concentration in their fund. GPs “right size” the position by splitting it between co-investors and their fund. For example, in the below illustration the GP’s private equity fund purchases a 70% controlling position in the target company, while the remaining 30% is purchased by two minority co-investors.
Co-investors allow the sponsoring GP to close a deal with the target company by providing additional capital on a timely basis. Without co-investors, the GP would likely be forced to either share the deal with a competing private equity firm or walk away entirely. Because co-investors are providing an important service to the GP, GPs will often agree to waive their “2 and 20” compensation model on co-investment capital, saving co-investors significant basis points in fees.
An Exclusive Club
Not surprisingly, the prospect of investing in private equity deals on a “no-fee” basis has created tremendous investor appetite for co-investment opportunities – especially those co-investments sponsored by top GPs. For these top GPs, participation in their co-investment opportunities is by invitation only. Those investors receiving such coveted invitations typically share three common characteristics:
- They are significant investors in the GP’s private equity fund (i.e., they are already a valued client).
- They possess the expertise to evaluate direct deals and make informed investment decisions.
- They have access to a significant pool of capital that can be deployed without delays.
As a result of Oxford’s decades-long experience sourcing private equity funds (i.e., our “Regent Street” platform) and direct deals (i.e., our “Mayfair” platform), we believe Oxford is uniquely situated to access attractive co-investment opportunities.
Arguably, investors in private equity funds have earned substantial excess returns relative to public equity markets. This return advantage comes despite a fee load that is typically higher than traditional investment classes. Private equity co-investments are hard-to-access direct private equity investments offered by fund GPs in need of additional capital to close a new deal. Sophisticated investors see co-investing as a means to dramatically lower fees, without sacrificing investment quality. Oxford’s scale, network and experience has uniquely positioned us to access and evaluate co-investment opportunities for the benefit of our qualified clients.
*Past performance is no guarantee of future results. The time periods illustrated may not represent current conditions.
**The amounts and returns represented are for illustrative purposes only and are not intended to represent actual returns that an investor should expect.
The above commentary represents the opinions of the author as of 10.25.19 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice.