In recent years, the appeal of equity co-investments has dramatically increased, as small and medium-sized businesses have sought out financing from alternative lenders that provide greater speed and flexibility. Specifically, banks and other traditional lenders found themselves facing increased regulatory control following the 2008-09 financial crisis, leading them to lend to larger corporations. This pushed business development companies (BDCs) and other alternative lenders to fill the breach with smaller enterprises.
In fact, it is estimated that in 2019, $66 billion of the $206 billion invested in “shadow capital” (referring to direct investments, co-investments, and separate accounts) was attributed to co-investments. In other words, co-investments accounted for nearly a third of what was invested in 2019, making this practice more prolific and popular than some might imagine.
And despite the pandemic and the strain it placed on relationships between general partners (GPs) and limited partners (LPs), the trend toward co-investments has continued; some GPs even turned to co-investments with trusted LPs during the pandemic for short-term security.
Investors sought creative, profitable ways to put their capital to good use, especially after government intervention bolstered the global economy and made capital more readily available. In the interest of high-quality assets, profitable investments, and cost-effective yet rewarding pursuits, GPs and LPs have continued to demonstrate a consistent (and in some cases, growing) demand for co-investment opportunities. Based on recent investment trends and economic patterns, the co-investment practice will likely be a lasting one.
What Are Equity Co-Investments?
Generally speaking, equity co-investments occur between individual investors and a more affluent individual or organization, namely a private equity fund manager or venture capitalist firm, for the purpose of financing a company. These partnerships allow investors to gain access to assets that, due to high fees associated with private equity firms and high capital requirements, would be difficult to obtain.
In some ways, co-investments are a form of direct investment, because they involve investors buying into a company through shared capital. Co-investments tend to be unique because of the variety of investor identities, equity division, and more, making them all the more appealing to investors who are seeking custom arrangements to suit their portfolio needs.
The advantage to the company, meanwhile, is that it is afforded the greater flexibility an alternative lender offers. Moreover, the lending process is more streamlined than in the case of traditional investors — i.e., the borrower can access capital more quickly, as it seeks to realize its growth initiatives.
How They Work
Compared to investments made by private equity or venture capital funds, co-investments tend to be relatively small; coupled with the low or non-existent fees associated with co-investments and the added benefit of ownership privileges, co-investors stand to reap promising rewards with a lower amount of risk than if they had participated in the investment alone. As with other investments, co-investors who allocate larger amounts of capital stand to benefit more, making co-investments appealing to investing entities with larger capital pools available to them.
Between 2012 and 2018, co-investment deals more than doubled in value to $104 billion, according to McKinsey; similarly, the number of LPs interested in co-investments also increased by 10 percent, marking a notable shift toward co-investment prioritization and value. Even individual private equity lenders have witnessed impressive performance among co-investments, with 80 percent of limited partners surveyed by Preqin reporting strong performances, some of which outperformed investments with traditional funds.
Co-investments benefit private equity sponsors and investors alike through shared capital, increased opportunities, and direct investment practices.
Structure
When broken down, the structure of a co-investment is fairly simple. An investor and private equity fund or venture capital firm contribute to a shared private equity fund; in turn, the fund is then used to invest into a company, granting majority ownership to the fund or firm and minority ownership to the investor. Rather than investing through a firm, co-investors instead invest in a single company through shared capital. While co-investors have access to the fund, the GP sponsoring the investment retains control, though co-investors are welcome to inquire about follow-up investments and the portfolio company.
Co-investments tend to last a few years, but the length can be extended depending on the preferences of the GP and co-investors. While there are certain commonalities among co-investments, the truth is that each deal is unique; GPs form co-investment funds to fulfill specific needs, making the funds uniquely crafted each time. Most co-investments entail the partnership of a GP and a trusted LP, but this is not always the case; the structure of a co-investment sometimes correlates to the size of the GP, as well, with smaller GPs being more likely to form a co-investment private equity fund than larger firms.
Pros & Cons
As with any type of lending, there are pros and cons to pursuing equity co-investment.
A company owner takes out such a loan knowing that there is an alignment of interest between him- or herself and the co-investor. As a result, the alternative lender tends to be more patient with a borrower, knowing both parties are in the same boat. That gives the borrower some measure of security, as he or she is secure in the knowledge that a default is less likely to be called in.
As mentioned earlier, small and middle-market businesses often cannot rely on traditional loans to sponsor growth initiatives and instead must turn to alternative financing. Following the 2008-09 financial crisis, bank regulations increased, making it more difficult for smaller companies to obtain suitable loans.
Similar to other alternative lender benefits, co-investments offer increased flexibility and a simple, efficient loan process.
The downside to equity co-investment for the borrower is that equity is more expensive than debt, for this reason: Debt is finite, as it consists of the interest a business owner pays on a loan, while equity is not. That’s because the borrower, having sold an interest in his or her company, must consider the interest paid in comparison to the profits that might be lost.
Additionally, the GPs and LPs face risks, in regards to defining terms, structure, due diligence, and more. It is important that all parties ensure they are in agreement regarding such details prior to finalizing the deal. Additionally, some GPs may not want to participate in co-investments because of the costs associated with establishing and reporting a specialized vehicle for each investment. Interested parties should be sure to calculate any related costs or fees when considering a co-investment opportunity to more accurately identify the ratio of financial risk and potential reward.
Conclusion
The rise in popularity of co-investments is rooted in patterns of success and opportunity. With numerous advantages to LPs and GPs alike, including higher return potential, lower fees, increased flexibility, and opportunities for connection and expansion, co-investments can be excellent options for investors and firms looking to expand their portfolios and facilitate growth. These short-term investments can bolster individual portfolios and assist firms in capital generation, contributing to their prominent appeal.
If you are interested in co-investment opportunities, consider taking time to review Saratoga’s investment portfolio; if our experience and expertise are suitable for your co-investment inquiries and investing needs, contact us so we can help.