A growing interest by large limited partners (LPs) to either co-invest or directly invest in corporate equity financings has led private equity (PE) firms to respond by facilitating investments in deals outside these managers' primary funds.
The trend reduces the overall average management and carry fee percentages paid by large LPs, but allows PE firms to maintain or increase overall investment levels, according to Fitch Ratings.
As the PE sector further grows its total assets under management, Fitch believes that permitting large LPs greater investing flexibility and lower fees is an unsurprising result, and overall a neutral impact to the sector.
Alternative investment managers have long provided co-investment opportunities to select large LPs, but the demand for co-investments appears to be on the rise, particularly as interest rates remain low and investor allocations to alternative strategies grow.
More co-investing has coincided with increased participation from sovereign wealth funds, which often have the ability to make relatively large commitments to alternative firms. In exchange for those large checks, LPs are increasingly seeking flexible investment structures and fee breaks.
Direct and direct co-investments bypass funds and typically come with no fees, while co-investment funds have incentive income sharing arrangements – at times a one per cent management fee and 10 per cent carried interest – lower than the more standard two per cent management fees and 20 per cent carried interest charged by many PE general partners. To the extent that LPs co-invest through funds, PE firms gain more flexible, committed capital, still maintain adequate fee economics, and provide large LPs greater optionality for their PE allocations.
Data from a survey of limited partners completed by Preqin earlier this year confirmed that the co-investment trend should continue. The survey showed that of the group that already have co-invested alongside a private equity firm, 56 per cent planned to increase their activity in this type of investment over the next 12 months.
The Preqin survey also noted that of the limited partners interviewed that already invest directly on a proprietary basis, 52 per cent planned to increase their direct investment activity in the next 12 months. Fitch views this as more of a threat to the existing alternative investment manager model. However, this trend is likely to remain confined to those LPs with significant assets under management that can achieve the necessary economies of scale associated with employing a large team of originators and investment managers.
While co-investment structures lower the average management fee rates that the private equity industry assesses per dollar of assets, co-investments often provide private equity firms with more flexibility in executing larger transactions, meaning they do not need to locate third party capital to complete a deal because the co-investment commitments can fill the gap.
Private equity managers are seeing a growing amount of capital coming into the space. For example, three quarters of the institutional asset managers based in Asia, including sovereign wealth funds, made new commitments to private equity in the first half of 2014, according to Preqin. This compares to 65 per cent of institutional asset managers in North America, and 56 per cent of institutional asset managers in Europe. The survey data also reflected that 44 per cent of limited partners invested in private equity were below their target allocations.
