Overview
When a private equity fund-of-fund co-invests, it invests directly into an individual company that is managed by a private equity manager. Co-investments, when wisely employed, can add considerable benefit to a fund-of-funds' portfolio.
Lowering risk
In general, investing with a private equity manager involves investing in a "blind pool" of capital - the ultimate investments in the fund are unknown at the time of investing. This is why due diligence undertaken by the fund-of-fund manager on the private equity manager is critical. Co-investments give a fund-of-fund manager an opportunity to assess the strength of the individual company, and they are no longer investing "blind". Co-investments are a vital way for the fund-of-funds manager to see precisely how a private equity manager makes its investment decisions, by viewing the decision making process in action. For a fund-of-fund manager, it is really the only time to truly "get in the trenches" with a private equity manager and see how the manager really formulates an investment decision.
While taking advantage of the benefits offered by co-investing, a fund-of-funds manager always needs to be on the look out for underperforming investments that the underlying fund manager may be attempting to offload onto the fund-of-funds manager. To a large degree, continual monitoring of the underlying managers ensures that this does not happen. In addition, it is critical that a co-investment is undertaken on the same terms for all investors. In this way, managers cannot structure the deal to benefit themselves and disadvantage the fund-of-funds investor.
Reduced fees
Generally, little or no fees are charged by underlying manager for access to these co-investment opportunities. This results in lower overall costs to the investor and therefore increased potential for higher returns from the fund.
Increased market power
A fund-of-funds manager who undertakes co-investments becomes more sought after by underlying private equity managers. This is because the fund-of-fund manager is seen as being able to assist the private equity manager in future investments where there is a need for additional capital to be injected into a particular company. For example, this may occur when a company becomes too large for the private equity manager to invest in on its own accord, at which time the fund-of-fund manager may co-invest alongside the manager.
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