A 2012 report from Preqin stated that over 50% of limited partners are either actively seeking or considering co-investment rights when committing money to private equity funds and, in speaking with over 100 middle-market private equity funds over the past three months, we hear the same thing. On the surface, this is not surprising – by co-investing, LPs can allocate more capital to Companies they have confidence in without the “toll” of the general partners’ vigorish.
However, a recent study out of Harvard Business School shows that LP returns from co-investing or directly investing themselves are lower than the returns received from investments in private equity funds, net of the general partner’s “two and twenty” cut. This empirical study seems to indicate that limited partners should continue to invest through the private equity funds who, according to this study, appear to be doing something right on a regular basis or ensure that they increase the in-house investment skills and governance procedures for direct and co-investment initiatives. For the LPs still considering direct investments, consider the following:
- Direct Investing Core Competencies – Ensure that you have the core skills necessary for direct investing either resident within your organization or externally through vendor / partner relationships.
- Co-Investment Discipline – Have someone independent of your investment committee and the private equity fund review the deal and diligence documents that the general partner has generated and perform additional primary diligence that is situation-based.
- Operating Company Governance Procedures – Managing a direct private equity investment is not the same as managing a portfolio of investments through private equity funds. Ensure that you have operators with related industry and functional experience on your board and involved with the Company.
This week we heard from one general partner that “the market is such that limited partners are getting co-investment rights in their agreements, but few are actually invoking these rights and co-investing with us.” Perhaps with the development of the additional competencies discussed above, the limited community will enhance its direct investing competencies to maximize the IRR while minimizing the vig.
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