Co-investment opportunities have recently gained in popularity among institutional investors and other limited partners with increased leverage in private equity funds. As it happens, co-investments have also proved appealing to many PE fund sponsors.
There is every reason to expect this trend to accelerate in 2015.
Torys LLP looked at this issue in our recently released M&A Top Trends 2015 report. Because of the growing influence of co-investment in Canadian and global PE markets, my colleagues Cameron Koziskie, Joseph Romagnoli, Richard Willoughby and I thought we might share some further thoughts on the subject with readers of peHUB Canada.
In a PE co-investment arrangement, an investor commits to an M&A transaction alongside a sponsor’s primary fund. LPs are drawn to this activity as it gives them the chance to build out their market exposure, often on terms that include reduced management fees and sponsor carry. Additionally, they often have the option to select the deals in which to participate. This freedom is viewed as an advantage over, or a complementary strategy to, passive blind-pool fund commitments.
PE fund sponsors equally view co-investments as beneficial in the right circumstances. They provide sponsors with additional capital to manage large investments that might call for resources in excess of investment limits or comfort zones. In practice, co-investment deals also have the potential to deepen sponsors’ relationships with their LPs.
Other factors are also driving the rise in PE co-investments, each of which we expect to continue. They include:
Increased LP expertise
Leading-edge institutional investors, particularly Canadian institutional investors, have been developing in-house deal capabilities for years. Their success has inspired many other investors to emulate this model, and a natural first step in developing in-house expertise is to seek out co-investment deals.
Increasingly selective LPs
Many large LPs have become selective in their fund allocations, preferring to develop concentrated relationships with a limited number of PE fund sponsors. They will often only devote commitments to funds offering meaningful co-investment opportunities, frequently on a priority basis. The growing prevalence of these arrangements, which are often formally set out in LP side letters, has led to greater co-investment deal volumes.
LPs continue to seek ways to increase the net returns on their PE portfolios. Since co-investors often pay reduced (or no) management fees and carry entitlements on capital deployed to deals, the savings can help enhance their net returns. This contributes to further demand for co-investment opportunities.
Given the current seller’s market, more and more PE sponsors are looking to partner with others in order to share investment risk. Club deals (where a sponsor seeks to partner with others to complete an M&A transaction) have become less common in part because of the highly competitive deal environment and the decreased number of mega-buyouts since the credit crisis. Sponsors are instead turning to “friendly” parties (i.e., the sponsor’s own LPs) as deal partners.
Benefits to PE fundraising
The fundraising environment remains challenging for many. PE fund sponsors are keen to differentiate their funds from others, and a successful history of offering co-investment opportunities to LPs can give them an edge in the market. Additionally, the availability of co-investment opportunities has helped build relationships between sponsors and LPs and provided an incentive for future capital commitments.
Despite their popularity, co-investment is not for everyone, and sponsors often exercise judgement about when and to whom an opportunity is offered.
An ideal co-investor is an institutional investor with deep experience in M&A transactions and strong internal resources, which can facilitate quick decision-making and the meeting of funding and deal timelines. LPs with relevant expertise and networks that can enhance returns are also valuable co-investment partners.
To the extent that an LP expects to play an active role in a co-investment (through board seats, veto rights, etc.), a strong working relationship with the sponsor, and commonly held views about key deal drivers, are vital. Issues can and do arise down the road, however, including different time horizons. Such issues can result in friction that ultimately damages the LP-sponsor relationship.
Michael Akkawi is a partner at Torys LLP, and head of the firm’s Private Equity Group. Cameron Koziskie is a partner focused on corporate and commercial law that emphasizes private asset management, private equity and M&A. Joseph Romagnoli is a partner and practices in the areas of private equity, M&A and financing deals. Richard Willoughby is a partner and a senior corporate lawyer focused on M&A and securities transactions.
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