What it means
The arrangement exists because deals are sometimes larger than a fund can or wants to hold on its own. Rather than turn the transaction away or accept dangerous concentration, the manager offers the surplus equity to its own investors and to other institutions.
The deal completes, and the co-investor gains exposure without the usual drag of fees. The headline attraction is cost.
A private equity fund typically charges around 2% a year in management fees and takes 20% of profits above a hurdle, so removing those charges on part of the capital lifts the net return materially. The catch is that a co-investment is a single asset, not a diversified portfolio.
If that one company disappoints there is nothing else in the position to offset it, and the investor has none of the fund's cushion of twenty other holdings. Co-investors also get very little time to decide, often two to four weeks, facing a manager who has been working on the deal for months.
Adverse selection is the quieter risk: the worry that the deals offered out are the ones the manager is least keen to hold in full. Serious investors counter this by building genuine underwriting capability in-house and by declining far more often than they accept.
Co-investment rights are usually negotiated at the point of committing to the main fund and written into a side letter. Larger commitments generally earn priority access, which is one reason big institutions consolidate their manager relationships rather than spreading them thin.
In practice
Real-world examples.
Example
A public pension scheme with a $75,000,000 fund commitment is offered $12,000,000 of co-investment in a waste management business. Its internal team spends three weeks on diligence and accepts, reducing the blended fee rate across its private equity programme.
Example
An infrastructure manager needs $400,000,000 of equity for a fibre network but its fund can only write a $250,000,000 cheque. It syndicates the remaining $150,000,000 to three of its largest investors as co-investment.
Example
A family office declines a co-investment in a retail chain despite attractive terms, because its portfolio already has heavy consumer exposure. The discipline costs it a good deal that year but avoids doubling down on a single sector.
Think of it
“Co-investment is investing alongside a fund-direct participation in specific deals.
Formula
Calculation
Fees avoided on a co-investment = (Management fee % x Co-investment amount x Years held) + (Carried interest % x Gain)
An institution puts $10,000,000 into a co-investment alongside a manager and holds it for five years, during which the business doubles in value to $20,000,000, a gain of $20,000,000 - $10,000,000 = $10,000,000.
Had the same $10,000,000 gone through the fund on the same terms, the management fee at 2% a year would have cost 0.02 x $10,000,000 x 5 = $1,000,000, and carried interest at 20% of the gain would have cost 0.20 x $10,000,000 = $2,000,000. Total fees avoided are $1,000,000 + $2,000,000 = $3,000,000.
Net proceeds are therefore $20,000,000 on the fee-free co-investment against $20,000,000 - $3,000,000 = $17,000,000 through the fund. That is a net multiple of 2.0 times rather than 1.7 times on identical underlying performance, which is the whole argument for co-investing.Case study
Seen in the real world.
Callisburn Retirement Fund is an illustrative, fictional pension scheme that decided to build a co-investment sleeve after calculating that fees were consuming roughly a quarter of its gross private equity returns. It hired two experienced underwriters and told its managers it wanted first refusal on deals in sectors it understood.
Over four years the scheme completed nine co-investments totalling $180,000,000. Seven performed in line with the underlying funds, one was written down heavily when a logistics business lost its largest customer, and one returned more than four times the money.
In this fictional case the concentration hurt in a single year but the fee savings and the outsized winner left the sleeve well ahead of the fund route. The lesson the trustees drew was that co-investment works only with enough deals to spread the risk and enough expertise to say no.
Watch out
Common mistakes.
- Treating a co-investment as free money because the fees are lower. The risk is concentrated in one asset, and a single failure can wipe out several deals' worth of fee savings.
- Accepting the manager's diligence without doing any. The manager's incentives and the co-investor's are not identical, particularly when the manager is trying to close a deal quickly.
- Doing one or two co-investments and calling it a programme. A handful of positions gives concentrated exposure without the diversification that makes the strategy work over time.
Questions
People also ask.
How many co-investments make a sensible programme?
Most institutions aim for at least ten to fifteen positions over a few years so that no single deal dominates the outcome.
Do co-investments always carry zero fees?
Not always, since some managers charge a reduced fee such as 1% and 10% of profits, which still improves on standard fund terms.
Can smaller investors access co-investment?
Rarely on a direct basis, though co-investment funds and multi-manager vehicles exist that pool smaller cheques into deal-by-deal exposure.
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