Co-investments: Are GPs and LPs on the same page?

Co-investments, specifically the deals where LPs join in on a specific investment with the GPs whose funds they invest in, are purportedly one area that benefited from the 2008 crisis and the subsequent shift in the GP/LP balance of power. In the West at least, the post-crisis dearth of leverage led to LPs stepping up as capital providers for deals, but on their terms, as co-investors. And Asia Pacific might seem a suitable venue for LPs seeking to use their GPs' expertise to gain exposure to a less well covered region. Yet feedback indicates that co-investments are by no means as prevalent, and LPs by no means as effective in sourcing them, as is commonly believed - for very good reasons.

Easy to come by?

LPs have a straightforward case for seeking co-investments, where they can get them. Doug Coulter, Head of Private Equity, Asia Pacific, with LGT Capital Partners, sees these from his firm's point of view as, "a way to increase our exposure to GPs we like, and give our investors access to interesting investment opportunities at lower fees and with lower risk as compared to doing direct deals." This tends to support the contention of another fund formation professional that LPs seek co-investments not least as a way of offsetting the effects of being cut back, as many are in the more popular funds.

For GPs, the attraction is less clear-cut. According to Pak-Seng Lai, Managing Director and Head of Asia at Auda International, "the rationale is that GPs may not be able to take up the full allocation of some larger deals, due to lack of capital or diversification constraints. So they tend to share these deals with their LPs." Yet GPs' responses to co-investment are, at best, variable. "In general, they are open to offer co-investments to their major LPs, provided that these LPs could response fast when a deal is offered to them," Lai avers.

Andrew Liu, Managing Partner and CEO at Unitas Capital, says that GPs tend to be "positive" towards granting co-investment rights, but this is not a universally held view. One leading co-investor LP, perhaps influenced by personal experience, reports that, "if GPs need additional capital or LP bring some value (e.g. Industry or market knowledge, or network), GPs are willing to provide. Overall, GPs seem to welcome capable LP co-investors." Other figures in the field, however, feel that co-investment rights are increasingly harder to come by for LPs, especially in Asia, where quality funds are highly sought after, and LPs have less negotiating leverage. Although co-investment rights are very important to some LPs, "sponsors with any kind of leverage resisted with all their effort, in a polite way," as a noted fund professional remarks.

The weakest link?

GP concern over co-investment deals may stem from selfish economic motivations, but it also has one other very practical aspect. According to one unnamed GP, at least some of the LPs who try to engage in co-investment may simply not be very good at it. The fears for a GP in such instances is that an LP granted co-investment rights and actually admitted into the deal process then becomes "the weakest link."

Partly to avoid this risk, when a co-investment happens, it is normally not done through the broader limited partnership agreement at all. Rather, an ad hoc fund vehicle is incorporated specifically for the co-investment deal.This makes it easier to manage the carry calculations and other economics of the deal: more importantly, perhaps, from the GP's perspective, it makes it easier to deal with issues of precedence among LPs. In each deal where co-investment crops up, GPs will generally want to put their strategic investors first as well as any LP with a significant angle to contribute, such as a local LP who may have been crucial to sourcing the deal. Blanket overall commitments to co-investment options hence lend to be shunned. As fund professionals attest, there is no one standard approach, and structures tend to be dictated deal by deal.

The GPs, meanwhile, might reasonably reflect that it is better to partner with a major direct investment entity than to bid against them on the same deal - especially when most co-investments concern large-scale opportunities that would require a consortium bid anyway. Also, LPs may make better co-investment partners than GPs, for purely competitive reasons. Lai sees this as a better option for many GPs "as compared to sharing the deals with other private equity funds, which will claim these deals as their ‘track records,' especially if they become successful." And, as he points out, "Certain LPs (especially industrial families and corporations) may bring strategic value to the co-investments."

Diligence is another important motivator for LPs who would like to take a major share of the opportunity but lack the time or the resources to diligence it properly. As Lai points out, "there is an assumption that GPs will practice extra caution for deals involving their LPs - they would risk damaging the GP/LP relationship if the deals turn bad." This tends to be very much down to the particular co-investment LP, though. As one says, "it is fair to say that the deals where we had a chance to do more due diligence produce better results."

Where and how to co-invest

Practical receptivity towards co-investments, where it can be found, tends to come only at the deal level, not at fund level. Although a few funds, especially newer and less popular vehicles, may be ready to offer co-investment rights to their LPs, as feedback from fund formation circles confirms, the more sought-after firms will generally give at best token promises on co-investment rights at the fund level. As another fund formation counsel notes, LPs may then receive co-investment rights in their side letters, to the extent these are allowed by the limited partnership agreement. Sometimes these may be are weak ‘indications of interest' in co-investments; in other cases, these are enforceable rights - either priority rights or rights to participate pro rata with any other LPs in co-investments.

Coulter puts the case for a GP to grant these rights. "Our preference is to source deals from the small or mid-market, local country funds, many of whom we have known or invested with for many years. In cases where we are an important LP, GPs are normally quite receptive as they know that attractive co-investment opportunities can be a differentiator when the time comes for us to look at the next fund." Interestingly, such funds are just the ones often cited as some of the best performers in Asian private equity.

The type of LP that seeks co-investment rights is fairly obvious, at least in larger major funds. "Who is starting major direct investment programs in their own right? They're most likely to want to do co-investments," asserts one fund formation authority. This tends to be the larger pension funds and funds of funds. Individual HNW investors, smaller family offices and other less powerful institutions tend to be far less active in the co-investment space. To confuse matters, some co-investment LPs may also do deals as direct investors, partnering with GPs on a peer basis, rather than as co-investors with funds they invest in.

And even then, some of the most ostensibly qualified LPs in Asia have been late or limited co-investors. The Government of Singapore Investment Corporation (GIC), for example, only did its first European co-investment deal in December 2009, partnering with EQT Partners on the EUR2.3 billion ($3.4 billion) secondary buyout of German media group Springer Science+Business Media from Cinven and Candover Partners, with GIC picking up 18% of the deal. As at end 2009, GIC had completed 11 co-investments overall.

Fees on co-investments?

Perhaps the most obvious driver for LPs to seek co-investments, Lai confirms, is that "as LPs typically do not have the resources to do a deal independently, so they prefer to tag-along GPs and leverage their due diligence resources." The prominent direct investment and co-investment LP confirms that co-investments lower the overall cost/ difficult to source deals directly in areas where the fund does not have meaningful sourcing capability. And from the GP side, Andrew Liu of Unitas remarks that, "LPs generally see co-investments as a way to improve their returns, as most co-investment opportunities for LPs are on a reduced or no fee/carry basis."

That said, the economics on a co-investment deal may not be that attractive. The question of whether an LP has to pay fees or carry on a co-investment deal remains open, and renegotiated case by case. In some instances, the LP may find it is paying the same management fees and share of carry that it would have to in a normal deal.

Needless to say, it makes little sense for an LP to participate in such deals without at least some experience and capability in managing or supporting an investee company. In such cases, LPs may undertake co-investments to gain exposure or knowledge in a sector or region they do not currently have in their own portfolio. And, as leading co-investment specialists attest, they will often pick funds with a particular sector or domain knowledge to invest with, to learn from that GP as well as to gain the benefits of a particular niche investment. LPs may also seek to do co-investments to get closer to their GPs. As Lai says, "by working on co-investments, LPs get to build the relationship and learn more about the GP's investment process."

An LP's co-investments also are an opportunity to field-test the assumptions that made it commit to the GP in the first place. As Coulter points out, "we have a very high level of conviction in these managers and expect that general deal flow will be of a high-quality nature. We then have the opportunity to cherry-pick the very best opportunities, while ensuring our interests are aligned with the GP."

Overall, co-investments are likely to increase as the Asian industry matures, as in so many other specialized areas of the asset class. But they are just as likely to remain an arena for the respectful battle of wills between GP and LP, and a proving ground for the true capabilities of both.

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• Topics
• GPs
• LPs
• Investments
• Greater China
• LGT Capital Partners
• Unitas Capital
• Doug Coulter
• Andrew Liu