Characterise co-investing in private markets and weigh up its benefits and drawbacks.
The idea
Co-investment means investing directly in a specific deal alongside a GP, outside the fund, usually with reduced or no management fee and carried interest. The benefits are lower overall fee drag, the ability to size exposure to the deal, faster deployment that can soften the J-curve, and a closer relationship with the GP. The drawbacks are real. Adverse selection is one. The GP may offer deals that are too large for the fund, are riskier, or that it cannot place elsewhere, and the investor may have only a few weeks to diligence them. Concentration is another. One company replaces a diversified fund portfolio, so risk is much higher. The investor also needs its own team, speed and legal capability, and there is no GP loss-sharing. A common error is to treat co-investment as a free fee saving. The fee saving is offset by single-name risk and a weaker information position.
Formulas
Net return after a management fee and carried interest
Net = (Gross − fee) × (1 − carry)
- Gross
- the gross return
- fee
- the management fee rate
- carry
- the carried interest share of profit after the fee
With no hurdle and carry charged on profit after fees. Apply it to each sleeve, or each layer of a fund of funds, separately before weighting or chaining.
Variance of an equal-weighted portfolio of n similar companies
σp² = σ² × [1 ÷ n + (n − 1) × ρ ÷ n]
- σ
- the volatility of each company
- n
- the number of companies
- ρ
- the pairwise correlation between company returns
Assumes equal weights, volatilities and correlations. A co-investment in one name is the case n = 1, which carries the full single-company volatility.
A practice question
Co-investment in private markets is best described as:
- The purchase of an existing limited partner's fund interest on the secondary marketWhy not: This describes a secondary transaction, not a co-investment.
- An investment by a fund of funds in several underlying private equity fundsWhy not: This is a fund of funds, which adds an extra fee layer.
- The purchase of listed shares of the general partner's management companyWhy not: This gives exposure to the manager's fee business, not to the fund's deals.
- A direct investment in one deal alongside a general partner, outside the fund, usually with low or no fees - correct
A co-investment is made alongside the fund in a single transaction, typically with low or no management fee and carry because it is an arrangement outside the fund. The investor takes on deal-specific risk and needs its own capability.
A harder one
A general partner offers a limited partner a co-investment in a deal that exceeds the fund's concentration limit. The limited partner has two weeks to decide. Which risk should the limited partner be most alert to?
- Double fee layering, because the co-investment is charged both fund-level and deal-level feesWhy not: Co-investments typically bear low or no fees, so the double layer is not the problem.
- Loss of the illiquidity premium, because co-investments can be sold on a daily basisWhy not: Co-investments are illiquid private holdings, with no daily market.
- Adverse selection: the deal may be offered because it is larger, riskier or hard to place, with little time to diligence - correct
- Cross-collateralisation of the fund's other portfolio companies against the co-investmentWhy not: Co-investments are made outside the fund and are not cross-collateralised with its other holdings.
Information asymmetry and time pressure create adverse selection. The GP knows more about the deal, and may be offering it because the fund cannot hold more. The investor needs its own diligence capability and clear allocation policies.
The hardest tier
A limited partner has USD 100 million to invest. Option 1 puts 60 percent in a fund charging a 2 percent management fee and a 20 percent carry on profit after fees, and 40 percent in a co-investment charging 0.5 percent and 5 percent carry on profit after fees. The portfolio gross return is 16 percent in either case. The blended net return, with no hurdle, is closest to:
- 12.6 percent - correct
- 13.12 percentWhy not: Applies fund fees only to the fund and assumes the co-investment is fee-free, ignoring its 0.5 percent fee and 5 percent carry.
- 14.6 percentWhy not: Subtracts only the weighted management fees (16 - 1.4) and ignores carried interest.
- 11.7 percentWhy not: Applies the fund's 20 percent carry to the whole portfolio, including the co-investment.
Fund net = (16 - 2) x 0.8 = 11.2 percent. Co-investment net = (16 - 0.5) x 0.95 = 14.725 percent. Blended = 0.6 x 11.2 + 0.4 x 14.725 = 12.61 percent. Fee tiers must be applied to each sleeve separately before weighting.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Private Markets Investing (up to section 3.3.10)
- Account for why investors choose to put money into private markets.
- Outline the structures through which private assets can be held and contrast their features.
- Use and contrast the various ways of measuring private equity performance, outlining the strengths and weaknesses of each.
- Show how investors in private markets come to face different risks and judge how those risks can be measured.
- Explain what investors gain and what obstacles they meet when they reach private markets by way of a pooled vehicle like a private equity or private debt fund.