LPs face ‘huge risks’ on co-investments

Limited partners should question whether co-investments are within a manager's sweet spot, investors at PEI's Women in Private Equity conference said.

Co-investment management fees could become more common amid fears that limited partners are rushing into deals to avoid charges.

“Everyone is asking for co-investments,” Kaarina Suikkonen, managing partner at Swiss family office advisory Apaja, told delegates at Private Equity International‘s Women in Private Equity Forum on 21 November. “It used to be the way to reduce the fee drag and I think that you’re starting to see the managers asking fees for co-investments – so management fees and smaller carry.”

The warning follows a rise in the number of LPs seeking co-investment opportunities, with 42 percent expecting to deploy more capital via the strategy in the next 12 months, according to a September report from advisory firm Rede Partners.

Aberdeen Standard is among investment firms increasing their focus on co-investments, with up to 25 percent of its $14 billion private equity portfolio available for the strategy. Malaysia’s Employees Provident Fund, the sixth-largest pension fund in Asia by assets, is also pursuing co-investments to maximize returns and build up its private equity team’s capability, as sister publication PEI reported in October.

More than 60 percent of US fund managers surveyed for sister title pfm‘s Fees and Expenses Benchmarking Survey said they were already charging management fees and/or carried interest on their co-investments. Management fees on co-investments are, on average, half of those paid on a regular private equity fund commitment, according to research from alternative assets consultancy MJ Hudson.

Co-investments often enable GPs to acquire targets outside of their usual bite size and give LPs a chance to avoid the management fees. As demand for such deals increases, so too does the potential for investors to rush into deals that may not be right for them or the GP.

“We see some LPs who tend to do every co-invest deal that they are being offered and we actually worry about that,” Carolin Blank, principal at Hamilton Lane, told delegates. “We think it’s a huge risk for LPs to not be selective about that and we think some of them will make mistakes.”

Hamilton Lane’s dedicated co-investment team accepts just 6 percent of opportunities, Blank noted.

“What we’ve learned is we need to be very specific about what makes a good co-investment and have an early screening tool that allows us to say [whether] this is within the manager’s sweet spot,” added Elaina Elzinga, a principal at UK foundation Wellcome Trust.

“If it’s slightly off-piste, as sometimes they can be, or slightly larger, that’s when we become much more skeptical and generally tend to pass.”