A minority investment made by the co-investor into an operating company alongside a financial sponsor
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An equity co-investment (or co-investment) is a minority investment made by the co-investor into a company. The investment is made alongside a financial sponsor. An example of a co-investor includes institutional investors such as an insurance company, pension fund, or endowment.
The term minority investment means the co-investor owns less than 50% of the portfolio company. With the non-controlling share, the co-investor exerts little influence on the overall decision-making process. The investor making a majority investment into the operating company is the financial sponsor or private equity firm. Unlike the co-investor, the private equity firm exercises control over making decisions. Venture capital firms may also sometimes seek co-investors.
An equity co-investment is a minority investment made by the co-investor into an operating company alongside a financial sponsor. Co-investors invest alongside the private equity firm, not through the private equity fund.
Private equity firms benefit, as they can have more capital available to invest in other profitable projects and not just in a single transaction.
Institutional Investors can gain access to more information and access to due diligence.
Structure of an Equity Co-Investment
Understanding Equity Co-Investment
It is important to distinguish that in an equity co-investment, co-investors invest alongside the private equity firm, not through the private equity fund. The latter is the most common way that institutional investors invest in the operating company. As institutional investors invest in the main private equity fund, the private equity firm is given the authority to make decisions on the best investments to pursue.
Also, the private equity firm will maintain control over portfolio company holdings throughout their investment life. The institutional investor is obligated to participate in each investment made. Alternatively, the equity co-investment takes a different investment path from this typical scenario. The co-investor invests in a single operating company.
The co-investment vehicle will be accomplished through a separately structured set of agreements. In order for the institutional investor to participate in co-investment opportunities, they will submit an agreement or letter of interest to the private equity firm. The private equity firm will then decide to offer co-investment opportunities, though they are not obligated to do so.
Advantages of an Equity Co-Investment
Co-investors and private equity firms find equity co-investments to be attractive for several reasons.
1. More flexibility
Co-investments provide private equity firms with more flexibility. Private equity firms can have more capital available to invest in other profitable projects rather than in a single transaction.
2. Improved investor relationship and investment risk-sharing
Improved relationships with investors and the sharing of the investment risk are a few other examples of advantages to the main private equity firm.
3. Access to more information and due diligence
For the co-investors, the co-investment transaction may allow exposure to more information and access to due diligence or materials that they otherwise would not have. It can help the co-investor make better decisions and adjust their wider portfolio to best fit their investment needs.
4. Better fee arrangements
An additional advantage is that the institutional investor may receive better fee arrangements in the co-investment vehicle compared to investing in the main private equity fund.
A private equity firm that may wish to attract institutional investors could reduce fees or offer zero fees. Over the years, there’s been an increase in institutional investors submitting interest to co-investment opportunities.
Disadvantages of an Equity Co-Investment
Equity co-investments also come with risks for both the private equity firm and institutional investor.
1. More complex in nature
For the private equity firm, co-investment deals are a lot more complex. Strong communication and clear documents in the early stages are necessary to ensure the smooth running of the co-investment.
Examples of considerations include voting rights, responsibilities of management, expenses, fees, and more. While the co-investment opportunity may strengthen relationships, poor execution can just as quickly lead to strained relationships between the private equity firm and the institutional investor.
2. Greater risk of investment concentration
For the institutional investor, there is a higher risk of investment concentration. By investing directly into a single company, rather than a multitude of companies under a single fund, the portfolio is less diverse.
The institutional investor must also dedicate a lot of time and effort to the transaction.
3. Adverse selection problems
Last, adverse selection problems may arise if private equity firms were to delegate low-return investment projects to institutional investors and keep high-return investment projects to themselves.
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