co-investments in funds of funds and separate accounts · co-investments in funds of funds and...

BACKGROUNDWhile co-investing has been an important part ofprivate equity investing for many years, it has recent-ly become much more prevalent and an importantarea of focus for institutional and fund of fundsinvestors. Undoubtedly, investors have come torealise that there are significant quantitative andqualitative benefits to co-investing. Like much of pri-vate equity, co-investing has become much morecompetitive and allocations to the best deals are cov-eted. These trends will likely persist into the foresee-able future.

Co-investing can be done in all areas of alternativeinvestments including hedge funds, venture capital,mezzanine and buyout investments. Equity co-investment in buyout deals is the largest and mostrecognised segment and the focus of this discussion.The concepts and examples illustrated here, howev-er, can be applied to any type of co-investment,regardless of whether the co-investments are donethrough a fund of funds vehicle or an institutionalseparate account.

HISTORY OF CO-INVESTMENTCo-investment has been around for nearly as long asthe buyout industry itself. The practice becamemainstream during the mid to late 1990s, as institu-tional investors sought additional ways to deploycapital and general partners (GPs) began to see lim-ited partners (LPs) as helpful in executing largertransactions. Initially, it was common for equitysponsors to charge a reduced carried interest on co-investments. As the co-investment industrymatured, GPs began to view co-investment investorsas true partners. Deals were increasingly done withno management fee and no carried interest.

CURRENT STATE OF CO-INVESTMENTCo-investing is now a mainstream and acceptedcomponent of today’s private equity industry.

During fundraising, GPs are routinely asked by inter-ested LPs to address the likelihood of co-investmentin their next fund. While some GPs look at co-invest-ment as a requirement to entice certain LPs into afund commitment, the practice has evolved into animportant part of the business model for most equi-ty sponsors, offering a wide range of benefits to boththe LP and the sponsor. It is important to note thatwhile many LPs clamour for co-investment opportu-nities, a significant percentage of these LPs do nothave the staffing or infrastructure to respond to andcommit to co-investment opportunities in a timelymanner. LPs who effectively structure their organi-sations to execute on a co-investment programmefind themselves at a competitive advantage foraccess to these benefits.

THE BENEFITS OF CO-INVESTING TO THE LPQuantitative benefitsSubstantial quantitative benefits accrue to co-invest-ing LPs. These benefits are attributable to the posi-tive cash flow characteristics associated with today’sco-investment deals, including improved net returnand accelerated capital deployment. Because co-investing is done either free of management fee andcarried interest, or at substantially reduced rates,the LP will, by definition, improve its net investmentreturns relative to a programme that invests exclu-sively in funds. The improvement in net returns foran active co-investor can be as much as 300 basispoints or more as compared to a standard fundinvesting programme. By actively co-investing, an LPcan deploy capital with quality sponsors at an accel-

Co-investments in funds of funds and separate accountsBy Brian Gallagher, Twin Bridge Capital Partners

While co-investing has been animportant part of private equity

investing for many years, it has recentlybecome much more prevalent and an

important area of focus for institutionaland fund of funds investors.

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Chapter 9

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erated rate, which reduces the J-curve effect associ-ated with its private equity investing. A thoughtfuland well-constructed co-investment portfolio canalso allow the institutional investor to further diver-sify its portfolio and increase exposure to sectorsthat the co-investor prefers.

For many active co-investing LPs, co-investmentstypically comprise 25 percent or more of their over-all private equity exposure. Clearly, the quantitativebenefits experienced by the LP depend on the size ofits co-investment portfolio. Exhibit 9.1 highlightsthe primary quantitative benefits associated with asignificant co-investment programme.

Qualitative benefitsIn addition to the superior quantitative benefits foran LP, the qualitative characteristics associated withco-investing yield ongoing returns to the relation-ship between the LP and the equity sponsor. Co-investments allow the investor to develop closerelationships with senior equity sponsor profession-als. This allows the investor to obtain a firsthandunderstanding in how the sponsor executes the deal

process and to obtain better insight into the spon-sor’s capabilities and operating style.

Co-investments normally involve countless hoursspent with senior sponsors in the course of under-writing and management of a co-investment. This isinvaluable time that helps to develop strong rela-tionships and mutual trust. The co-investmentprocess is also an ideal time for investors to betterunderstand how the sponsor structures and sourcesits deals, performs due diligence, manages theinvestment, works with company management, exe-cutes on their plan and exits the investment. In addi-tion to an increased level of comfort, thisunderstanding helps the investor to identify thestrengths and weaknesses of their sponsor and tomake decisions accordingly. A better understandingof the capabilities of the sponsor may lead aninvestor to significantly increase its commitment tothe sponsor’s next fund. Conversely, an unsuccessfulco-investment experience may lead an investor toreduce its investment or not invest at all in the equi-ty sponsor’s next fund. The net result is that co-investment experiences help LPs make betterinformed decisions with regard to their GP relation-ships and fund investments.

BENEFITS TO THE EQUITY SPONSORThe benefits of co-investing are not restricted to theLP. In fact, co-investments generate several mean-ingful benefits for the equity sponsor. Foremostamong these benefits is the ability for the sponsor to

In addition to the superior quantitativebenefits for an LP, the qualitative

characteristics associated with co-investing yield ongoing returns to the

relationship between the LP and theequity sponsor.

CO-INVESTMENTS IN FUNDS OF FUNDS AND SEPARATE ACCOUNTS

Exhibit 9.1: Sample net cash Low by year – traditional funds of funds vs funds of funds with co-investment

Source: Twin Bridge Capital Partners.

$ m

illio

ns

-80

-40

80

120

-60

0

40

-20

100

20

60

Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 12 Year 13Year 11 Year 14Year 1

Co-investment drivesimproved net cash Eow and capital deployment

Funds of fundsFunds of funds with co-investment

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do larger deals than its funds may otherwise sup-port, while retaining control over the investmentnecessary to ensure success. The alternative for theequity sponsor is to pursue a joint investment withanother sponsor, which can lead to difficult gover-nance provisions and a decreased ability to effective-ly control operating decisions.

Additional sponsor benefits to co-investmentinclude an expanded LP market, closer LP relation-ships and the benefit of unique viewpoints broughtby the co-investor. Because co-investing has becomesuch a pervasive part of private equity and desiredby so many LPs, an equity sponsor that embraces co-investment can expand its universe of desirable LPs.Like the co-investor, the sponsor also develops acloser relationship with LPs through co-investing.Finally, a knowledgeable and experienced co-investor brings a unique viewpoint to the transac-tion and can add insight, relevant advice and anetwork of resources that can all serve to improvethe outcome of the investment. As with the LP,these benefits are realised through careful manage-ment by the equity sponsor throughout the co-investment process.

As with any investment, becoming part of the process is crucial to becoming part of the ben-efits. The next section describes how LPs and GPswork together to manage the co-investmentprocess effectively.

THE CO-INVESTMENT PROCESSEvery co-investor will have differences in how theysource, underwrite and manage co-investments.There are, however, many common features associ-ated with the construction of a successful co-invest-ment portfolio. The simplest approach to describeco-investing and its corresponding benefits, is tostep through the process of completing a co-invest-ment transaction (see Exhibit 9.2), including sourc-ing, due diligence, management of the deal andultimately investment realisation.

SourcingBecause sourcing for co-investments typically comesfrom existing fund commitments, it is important forthe co-investor to express a strong desire for co-investments both at the time of the fund commit-ment and through periodic follow up calls andmeetings. Just as equity sponsors call on intermedi-aries to generate deal flow, potential co-investorsmust be diligent in routinely conferring with theirfund relationships regarding their ability to partici-pate in potential co-investment opportunities.

The sponsor wants a co-investment partner who canrespond quickly to the opportunity and can meet thetimeline needed to close the deal. In recent years, thetimeline to win and close a deal has become verycompressed. This trend is unlikely to abate any timesoon. Typically, a sponsor will send to potential co-investors summary material that describes the trans-action and the investment thesis to be carried out bythe sponsor. Each co-investment institution will haveits own process and procedures for determininginterest in an investment. Co-investors differentiatethemselves by responding to these opportunities asquickly as possible, even if there is no interest in thetransaction. Equity sponsors will often state that apotential co-investor who quickly turns down a dealis much preferred to one that takes weeks to con-clude on whether or not it is interested.

Due diligenceOnce a co-investor has decided to move forwardwith a transaction, the due diligence phase com-mences. This phase can be lengthy and involve volu-minous amounts of material. Fortunately for the

The sponsor wants a co-investmentpartner who can respond quickly to theopportunity 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.

Exhibit 9.2: The co-investment process

Sourcing Due diligence Key terms andgovernance Post closing


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co-investor, the core due diligence on the transac-tion should have been led by a capable equity spon-sor and the co-investor should be able to rely on thiswork. The co-investor often elects to perform sup-plemental due diligence to improve its evaluation ofthe investment. Additional resources and relation-ships that may not be available to the equity sponsorare frequently called upon to provide advice,appraisals, and general information. The result isdiligence that is highly reliable and thorough.

Every transaction is somewhat different in the duediligence materials needed and produced. Typicalitems 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 thesponsor about an opportunity, it is common thatsome of the information outlined above has beencompleted, but not all of it. The co-investor willreview the initial and ongoing information with thesponsor as the due diligence material is completed.This process can take as little as weeks, but moretypically is completed over two to three months.

After the completion of all due diligence, each co-investor needs to formally commit to the co-invest-ment. This commitment is subject to thatinstitution’s underwriting and investment commit-tee requirements. While the process of committingto a co-investment may take weeks or months, equi-ty sponsors prefer that the co-investment partnermoves through the process in real time alongsidethe sponsor.

Key terms and governanceAfter formal commitment to a co-investment, thefinal step before funding is the completion of all ofthe legal documents. These include documents usedto acquire the subject company, as well as the docu-ments governing the terms between the equity spon-sor and co-investor(s). The legal documents used toacquire the company include the purchase agree-ment, debt documents and employment agree-ments. The co-investor will typically review thesedocuments to ensure that they understand the termsof the investment, but will generally have very fewcomments given that these documents were pre-pared by a capable equity sponsor and their legalcounsel. In effect, legal documentation that raises anumber of substantive issues become a due diligencequestion as opposed to a legal question.

The documents governing the agreement betweenthe sponsor and the co-investor should of course bereviewed in detail by the co-investor, with experi-enced legal representation. Often, these terms willbe documented in a limited liability company agree-ment that includes all of the equity investors as sig-natories. In this agreement, there are several keyterms that the co-investor will want to consider, par-ticularly in an effort to remain aligned with the equi-ty sponsor. These terms include:

• Pre-emptive rights. If the equity sponsor puts in newequity on any terms, the co-investor will want theright to invest its prorated share in the same deal.

• Tag-along rights. If the equity sponsor exits any orall of its investment, the co-investor will want to beable to tag along in the sale for its prorated amount.

• Registration rights. If the exit for the investment isa public offering, the co-investor will want to beable to register and sell its shares alongside theequity sponsor.

• Information rights. The co-investor will wantaccess to at least quarterly financial informationon the performance of the company.

Depending on the size of the co-investor’s invest-ment, a board seat or board observer seat may bewarranted. Typically, if a co-investor has 20 percentor more of the equity in a deal, the co-investorshould expect a seat on the company’s board; if a co-investor has 10 to 20 percent of the equity, a boardobserver seat is more typical; below 10 percent ofthe equity, the co-investor will typically not attend

While the process of committing to a co-investment may take weeks or

months, equity sponsors prefer that the co-investment partner movesthrough the process in real time

alongside the sponsor.


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board meetings and will rely on its financial infor-mation rights to remain informed. Proper structur-ing with regard to each of the rights outlined aboveis important for the co-investors to feel aligned withthe equity sponsor.

Post closingThe role of a co-investor after closing the transac-tion is significantly different from the role of thesponsor. The equity sponsor will spend considerabletime managing the investment and conferring withmanagement regarding operating issues, acquisi-tion opportunities and other items. The co-investorwill monitor the investment’s performance closely,either directly through board participation or peri-odic discussions with the sponsor. Depending onthe nature of the investment, there may be a needfor additional equity to execute acquisitions. Inthese cases, the role of the co-investor is moreimportant and the time spent monitoring the dealwill be more considerable.

MYTHS ABOUT CO-INVESTINGWhile the benefits associated with co-investing aresignificant and the process fairly straightforward,confusion persists within parts of the institutionalinvestor community with regard to downsides asso-ciated with co-investing. These “myths” includeadverse deal selection concerns, rights afforded toco-investors as part of their transactions and under-estimation of the effort required to execute a suc-cessful co-investment programme.

Some institutional investors believe that co-invest-ing leads to adverse deal selection. Their concern isrooted in a belief that equity sponsors will only showtheir worst deals to co-investors and keep the mostpromising deals for themselves. This belief runscounter to the experience of most co-investors anddoes not pass the reasonableness test for a numberof reasons. First, equity sponsors do deals they thinkwill perform well and will meet return hurdles.Sponsors, however, do not have prescient knowl-edge of which deals will work perfectly and whichwill not. Second, and perhaps more importantly,equity sponsors value and need their LP relation-ships and therefore strive to ensure that co-invest-ment LPs are satisfied with the sponsor’sperformance. It is not in the best interests of anyparty, therefore, to present a substandard deal to a

potential co-investor and place an important rela-tionship at risk.

Another myth exists with regard to a potential co-investor’s rights in a transaction. Some perceive theco-investor as a marginalised player in deals. Thereality is that a fine line exists between a co-investorallowing the sponsor the freedom to execute on itsplan and the co-investor ensuring that their inter-ests are protected to the extent possible.Sophisticated co-investors, however, often have theability to manage this line through active involve-ment in the deal process and by continuing to par-ticipate post close. These investors will determinewhich minority rights are critical to ensuring a sat-isfactory outcome. They may also supplement thepoint of view they bring through board or observerseats, and may be critical in helping finance thefuture needs of the company. These opportunitiesallow the co-investor the proper rights to activelymanage their investment.

Arguably the most common myth seen today is thatco-investing is a simple business and an easy exten-sion 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 andscience to managing a co-investment programmeand the skills needed are developed through yearsof experience.

Some of the parties described above see their co-investment role as passive, including participation inall deals presented by their fund relationship. Thehistory of the buyout industry reflects countlessinstitutions that underestimated the time and effortthat goes into building and maintaining a successfulco-investment programme. As a result, there are afinite number of institutions today that are wellknown and well regarded as outstanding co-invest-ment partners. These partners spend significant

While the benefits associated with co-investing are significant and the

process fairly straightforward, confusionpersists within parts of the institutional

investor community with regard todownsides associated with co-investing.


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time making independent decisions and participat-ing heavily in the co-investment process. The mostsuccessful of these institutions continue to seethrough the myths today and remain diligent aboutthe selection of their partners and independentabout their decisions.

SUCCESS FACTORS IN CO-INVESTINGMany factors determine success in co-investing.First and foremost is experience. A co-investor whohas invested in many deals over numerous businesscycles develops invaluable experience and insightinto what deals will work and which will not.Quantity and quality of co-investment deal flow is afunction of the reputation and experience of the co-investor. Nothing is more important to an equitysponsor than a co-investor with experience, a stellarreputation, an ability to commit quickly to a poten-tial deal and to stick with the diligence alongsidethe equity sponsor until the deal closes. It shouldalso be noted that a co-investor builds its reputationby being a supportive partner in good times andbad. There will be circumstances in which a dealdoes not perform, necessitating corrective actionand additional equity. It is in these situations wherean experienced and responsive co-investor can dis-tinguish itself.

Successful co-investors must also take an objectiveand dispassionate view of each opportunity present-ed. Equity sponsors can become enamoured with acompany or management team. A good co-investorwill try to discern if the investment strategy and theskills of the sponsor warrant an investment.Experienced co-investors will often do only a frac-tion of the investments offered, so selectivity is animportant factor to be considered. Turning down aco-investment that a sponsor believes strongly in is adelicate process that can test the strength of the fundrelationship.

THE FUTURE OF CO-INVESTINGCo-investing will persist as an important and growingsegment of the private equity industry into the fore-seeable future, with both LPs and equity sponsorscontinuing to seek the benefits afforded by the co-investing relationship. While some recent activityshows equity partners partnering on investments tothe exclusion of co-investors, the difficulties in gover-nance and increased scrutiny of regulators makethese arrangements tenuous. As a result, traditionalco-investment LPs will play an increasingly importantrole in helping sponsors complete future investments.

As institutions continue to add co-investing to their listof investment activities, however, the search for top-performing co-investment partners will becomeincreasingly competitive. Just as traditional fundinvestors relentlessly pursue first quartile fund invest-ments, expectations for co-investments will be similar.The ability to achieve superior co-investment resultswill continue to be defined by those institutions thatalign with experienced and proven professionals exe-cuting on a proactive and thoughtful programme.

Many factors determine success in co-investing. First and foremost is

experience. A co-investor who has investedin many deals over numerous business cyclesdevelops invaluable experience and insight

into what deals will work and which will not.


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Brian Gallagher is a managing partner of Twin Bridge Capital Partners (Twin Bridge). Based in Chicago, Twin Bridge focuses on investingin middle-market buyout funds and co-investments in North America. Twin Bridge currently manages over $500 million in separateaccounts. Mr Gallagher has spent most of his career in the middle-market buyout industry, having previously worked at UIB Capital, PPMAmerica and Arthur Andersen. He received his MBA at Northwestern University’s Kellogg Graduate School of Management, and a BA inaccounting 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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