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Co-investments are on the rise as fund managers turn to new sources of capital and their investors look to reduce fee burden.

The growth of co-investments—whereby LPs make direct investments alongside their fund managers—comes amid a difficult fundraising market, an industrywide pullback on debt financing in PE transactions, and a rise in independent sponsors looking for investment partners.

Total capital raised for co-investments with PE investment managers grew from $6 billion in 2015 to $10.3 billion in 2022. While fundraising declined from 2021 to 2022, levels still remained historically elevated, according to PitchBook data.

So far this year, PE firms have raised three funds with a total of $100 million for co-investment transactions.  
"We're seeing more deals," Andrew Bernstein, head of private equity at Capital Dynamics, said. Capital Dynamics is a PE and credit shop that co-invests with sponsors in middle-market tech and business services companies.

Co-investments are an effective means for LPs to reduce their fee burden. When investing via a commingled fund, LPs typically pay a 2% management fee and 20% carried interest on the fund returns. However, through co-investing the LP pays either a lower fee percentage or nothing at all.

Securing such deals has become a higher priority as LPs turn more conservative during the current economic downturn.

The co-investment strategy is also growing in appeal for PE firms that feel pressured to write bigger equity checks as leverage costs rise.

Private market valuations are still high compared to historic levels. The average purchase multiples for US leveraged buyouts over last year is 11.47x pro forma adjusted EBITDA, compared with 11.01x in 2021, based on syndicated leveraged loan transactions tracked by LCD.

However, the cost of debt to fund buyouts has risen as a result of higher interest rates and a tighter credit market.

PE firms can't structure deals with as much leverage as they could when interest rates were low. As a result, many are forced to enlarge equity contributions to fund buyouts, which has opened up more co-investment opportunities.

"They would rather take less debt and raise more equity for deals from their own LP base, who are friendlier capital providers," said an investor managing funds that offer co-investment opportunities in buyouts.

The need for more equity financing and LPs' desire for lower management fees aren't the only factors behind the rise in co-investments. An increasingly difficult fundraising environment is also driving growth.

The total number of PE funds nearly halved from 1,129 in 2021 to 597 in 2022 as LPs became increasingly cautious about deploying capital and funneled more commitments to experienced managers. The fundraising environment hit new managers particularly hard: First-time PE funds saw their lowest fundraising numbers in nine years.

"As a result, GPs didn't have full confidence that they would get to their target fund size, but they didn't want to compromise the size of the companies that they were buying, so in order to fill the equity gap, they went to the co-investment market," Bernstein said.

Filling out equity checks with direct LP capital also allows PE managers to spend more time raising their next commingled funds.

"Some GPs are using co-investment as a way to extend the investment period by having less concentration within their portfolios, so that they can be out of the market for longer, " Rishi Chhabria, partner at advisory firm Campbell Lutyens, said.

The rise in co-investments can also be attributed to the growing market of independent sponsors, PE experts and ex-investment bankers looking to acquire a company without a fund or without advance equity financing. In a difficult fundraising environment, these types of structures are attractive to managers, particularly would-be GPs, allowing them to work with a single or select number of investors rather than calling on multiple investors to raise capital for a fund.

"This market has really exploded over the last several years to the point where we see several independent sponsor deals every week," Bernstein said.

By definition, independent sponsors acquire their assets through direct and co-investments, bypassing the PE fund structure. The independent sponsor structure is particularly helpful for new and emerging managers during tight fundraising periods. As the PE market has matured—reaching $4.6 trillion in AUM by the end of 2021—it has also become a lot more competitive with new funds and managers saturating the marketplace.

For new and emerging managers, this highly competitive environment makes it even more challenging to get their operations off the ground.

"It becomes more difficult for those professionals to establish credibility with the LP market," Adam Bragar, head of US private equity at Willis Towers Watson, said.

New and emerging managers can develop a track record through independent sponsorship, partnering in direct and co-investments with LPs and building a repertoire of deals to showcase during future fundraising periods, Bragar added.

Bragar said he expects co-investment activity to continue at its current pace, at least in the short term, as the challenging fundraising environment persists. The question then becomes what will happen to co-investment activity when fundraising activity eventually recovers. According to him, it's not going away.

"In my opinion, the entire conversation between LPs and GPs is going to change because co-investment has played an increasing role in LPs' portfolios," Bragar said.

Featured image by Gajus/Shutterstock

This article originally appeared on PitchBook News