Co-Investment in Private Equity: How It Works, Structures, and Benefits

Co-investment in private equity allows investors to invest alongside a lead investor, typically a private equity firm, in specific deals. This approach offers tailored investment strategies and access to high-quality opportunities that might otherwise be unavailable. With its rising popularity, understanding co-investment structures is essential for optimizing portfolios.

Typical Participants in Co-Investments

Co-investments bring together diverse participants, each contributing unique resources and perspectives. Institutional investors, such as pension funds, insurance companies, and sovereign wealth funds, often pursue co-investments to enhance returns while maintaining control over investment decisions. Their substantial capital reserves and long-term investment horizons make them ideal partners.

Family offices, representing ultra-high-net-worth individuals and families, also play a key role, using co-investments to diversify portfolios beyond traditional asset classes while aligning investments with specific interests and values. This personalized approach often reflects clients’ financial and ethical goals.

Private equity firms typically act as lead investors, offering industry expertise, deal-sourcing capabilities, and operational knowledge. These firms manage the day-to-day operations of investments, enabling co-investors to benefit from their experience without direct management involvement.

Deal Structures

Co-investment deals can be structured in different ways, each with its own advantages and challenges. The three primary structures—Direct, Syndicated, and Special Purpose Vehicle (SPV)—cater to varying investor needs and risk tolerances.

Direct

In direct co-investments, investors participate directly in a specific deal alongside the lead private equity firm. This structure offers transparency and control over invested capital and is particularly attractive to institutional investors with the necessary expertise. However, it requires significant due diligence and independent risk assessment. Metrics such as internal rate of return (IRR) and net present value (NPV) are critical for evaluating potential returns.

Syndicated

Syndicated co-investments involve a group of investors pooling resources to participate in a private equity deal, usually led by a private equity firm. This approach provides diversification, enabling investors to spread capital across multiple investments, thereby reducing risk. By leveraging the lead investor’s due diligence, participants can reduce their individual analysis burden. Profit allocation, voting rights, and exit strategies should be carefully aligned with investor objectives.

SPV

A Special Purpose Vehicle (SPV) is a separate legal entity created for a specific co-investment deal. SPVs limit liability to the capital invested and can facilitate tax efficiency, depending on jurisdiction and tax status. Investors should be aware of regulatory requirements, including compliance with financial reporting standards such as IFRS or GAAP, to ensure accurate reporting.

Capital Commitments

Capital commitments refer to the financial resources investors pledge to a specific deal. These commitments dictate the amount and timing of capital deployment, making them crucial for managing liquidity and ensuring obligations are met.

Investors should understand the timing of capital calls, which request funds when needed. Staggered capital calls are common, offering flexibility in cash flow management. Missing a capital call can result in penalties, such as reduced ownership or forfeiture of investment rights.

Fee Arrangements

Fee structures in co-investments are often more favorable than those in traditional private equity funds. Co-investors may benefit from reduced or waived management fees, as lead firms often earn compensation through other avenues, such as fees charged to portfolio companies.

Carried interest, typically 20% to 30% of profits, may be adjusted in co-investments to reflect direct participation, creating a more favorable profit distribution for co-investors. These details should be clearly outlined in the co-investment agreement to ensure alignment of interests.

Tax Considerations

Tax considerations significantly affect net returns for investors. Tax treatment varies by jurisdiction, portfolio company location, and investment structure. Evaluating these factors is essential for optimizing after-tax returns and maintaining compliance with tax laws.

Income from investments—whether dividends, interest, or capital gains—is subject to different tax rates. International investors may face withholding taxes, influenced by tax treaties. Pass-through entities, such as limited partnerships or SPVs, are often used to avoid double taxation. However, investors should be prepared to file tax returns in multiple jurisdictions and address any restrictions on deducting expenses or losses.

Exit Options

Exit strategies determine how and when investors realize returns. Co-investors often have more influence over exit decisions compared to traditional private equity funds, requiring careful planning to align with financial goals.

A common exit option is a trade sale, where the portfolio company is sold to a strategic buyer. This can generate significant returns if the company has achieved strong growth but may involve lengthy negotiations and due diligence. Tax implications, such as capital gains taxes, should be factored into the decision.

Another option is an initial public offering (IPO), where the portfolio company lists shares on a public stock exchange. IPOs provide liquidity and may benefit from market-driven valuation increases, though they carry risks such as market volatility and regulatory compliance requirements. Co-investors should assess the portfolio company’s readiness for public markets and develop a clear exit plan.