A co-investment is a direct minority equity stake that limited partners make alongside a private equity sponsor in a specific portfolio company, typically with reduced or zero management fees and carried interest. Co-investments let LPs lower their blended fee burden while concentrating exposure in preferred deals, but they demand faster underwriting and accept limited governance rights.
For finance professionals, co-investments can meaningfully improve net returns when structured correctly. They also create allocation conflicts, information gaps, and execution risk that can damage LP relationships and portfolio performance if handled poorly.
Sponsors use co-investments to plug equity gaps when deals exceed fund concentration limits, win competitive auctions by demonstrating additional capital sources, and deepen relationships with key LPs. Limited partners deploy co-investment capital to reduce their blended fee load, gain targeted exposure to specific assets, and accelerate capital deployment when primary fund pacing lags.
The economic tension is straightforward. Sponsors want to avoid diluting fund level carried interest while solving capital needs. LPs want access to the sponsor’s best deals at the lowest cost. This creates recurring disputes over deal allocation, follow on capital requirements, and exit timing that investment and portfolio teams must anticipate in their models and investment committee memos.
A 2023 Coller Capital survey found that 87 percent of LPs cite reduced fees as co-investments’ primary attraction. But several 2024 LP surveys reveal persistent concerns that sponsors reserve the most attractive upside for main funds or use co-investments to offload marginal deals that strain concentration limits. For analysts screening deals, an early question should be whether a co-investment is being offered because the deal is compelling or because the fund is constrained.
The math matters for portfolio construction. Assume a sponsor’s fund charges 2 percent management fees and 20 percent carry above an 8 percent hurdle. A no fee, no carry co-investment that represents 30 percent of an LP’s total exposure to that sponsor will meaningfully reduce the blended cost, especially on successful exits where carry becomes material. In practice, this shows up as a higher net internal rate of return for the LP relative to the gross deal IRR, a dynamic closely tied to how private equity fee structures are negotiated.
Most co-investments use a dedicated special purpose vehicle that aggregates co-investor capital and invests alongside the main fund. US sponsors typically use Delaware limited partnerships or LLCs. European sponsors favor Luxembourg special limited partnerships, Irish ICAVs, or UK limited partnerships, depending on the portfolio company’s location and investor tax needs.
Cross border deals introduce intermediate holding companies in Luxembourg, the Netherlands, or Ireland to manage withholding tax and treaty access. The co-investment SPV usually sits at the same level as the main fund to ensure parallel economics and governance so that models assume the same cash flow profile and exit timing for fund and co-invest capital.
Ring fencing is essential. Co-investment SPVs are bankruptcy remote from both sponsor and main fund, with no cross collateralization and no recourse beyond committed capital. Co-investors generally provide no guarantees to portfolio company lenders. This limits downside but also limits influence when portfolio companies face distress, which is relevant for anyone underwriting downside cases or exit strategies.
Regulatory changes add friction more than they change economics. The US Corporate Transparency Act requires beneficial ownership reporting for most US SPVs formed after January 2024. In Europe, many co-investment vehicles are treated as alternative investment funds under AIFMD, which drives additional reporting and cost but usually does not change the commercial terms.
Capital flows follow a simple pattern. The sponsor signs a purchase agreement through an acquisition vehicle owned by the main fund and co-investment SPV. Equity sizing includes the main fund’s commitment up to concentration limits plus a defined co-investment tranche that must be placed quickly with LPs.
After signing, sponsors distribute co-investment summaries to selected LPs with proposed investment size, valuation, abbreviated underwriting case, and timeline. LPs that confirm interest complete KYC and execute subscription agreements, typically within 1 to 4 weeks. For deal teams, this compressed window means the co-investment case must be underwritten largely off the sponsor model and a limited data pack, with little time for full independent diligence.
At closing, LPs fund the co-investment SPV, which wires equity to the acquisition vehicle. In smaller deals, LPs may subscribe directly into portfolio company equity to avoid SPV costs. In either case, the capital stack and distribution waterfall should be reflected consistently in the LBO model.
The waterfall operates at two levels. Portfolio company cash flows service debt first, then distribute residual cash to equity holders pro rata. At the co-investment SPV level, distributions pass through to LPs net of any management fees, carry, or expenses per the co-investment waterfall. Analysts should model the SPV level as a thin layer that may introduce small timing differences or expense leakage but is usually economically neutral in no fee structures.
Liquidity mechanisms are rare. Co-investments are structurally illiquid with transfers restricted by multiple agreements and often requiring sponsor consent. This illiquidity aligns co-investor and sponsor time horizons but creates portfolio construction risk for LPs that may need to rebalance commitments or manage denominator effects in stressed markets.
The core document is the co-investment or subscription agreement between the SPV and each co-investor. This governs capital commitments, funding mechanics, fee arrangements, and transfer restrictions. Co-investors typically provide limited representations on their status, authority, and sanctions compliance, so the legal negotiation is often lighter than a full fund closing.
At the portfolio company level, co-investors accede to the shareholders’ agreement through a joinder rather than negotiating terms directly. This limits their ability to influence governance, board composition, or exit processes. Investment professionals should assume that co-investors are price takers on strategic decisions and cannot rely on governance rights to fix structural issues identified during diligence.
Information rights are typically narrow. Co-investors receive quarterly reporting aligned with main fund cycles, annual audited statements, and notice of material events like refinancings or covenant breaches. Board observation rights are reserved for large co-investors or strategic partners, so most LPs will underwrite with the expectation of limited ongoing visibility.
Large LPs often negotiate side letters with most favored nation rights, enhanced reporting, and tailored transfer provisions. These must be documented carefully to avoid regulatory issues around preferential terms, especially under newer SEC private fund adviser rules that require disclosure of preferential co-investment allocations.
Co-investment fee structures fall into three categories. No fee, no carry arrangements charge no additional fees beyond those paid to the main fund. Reduced fee structures apply modest management fees, typically 0 to 1 percent annually, and reduced carry of 0 to 10 percent above the same hurdle as the main fund. Parallel fee arrangements combine full main fund economics with a smaller co-investment overlay, which is less common among sophisticated LPs focused on fee efficiency.
The return impact can be substantial. Consider a deal that returns 3x gross over five years. An LP investing 70 through the main fund and 30 through a no fee co-investment will achieve better net returns than an LP with 100 percent main fund exposure under a standard 2 and 20 structure. For associates building models, it is useful to run sensitivity cases where the co-investment sleeve is scaled from 0 to 40 percent to show how net IRR and multiple on invested capital change as fee free capital increases.
Tax efficiency varies by structure and jurisdiction. US investors often prefer pass through taxation at the SPV level to preserve income character and enable treaty benefits. Non US investors may use blocker corporations to manage US effectively connected income. Recent changes in the US, UK, and EU have tightened requirements for carry to qualify for capital gains treatment rather than ordinary income, which can influence how sponsors think about carried interest across fund and co-investment vehicles.
US co-investments rely on Securities Act exemptions like Regulation D, offered only to accredited investors and qualified purchasers. The SEC’s private fund adviser rules require enhanced disclosure of preferential terms, including co-investment allocation and fee arrangements, which has pushed sponsors to formalize allocation policies and document them clearly for LPs.
In Europe, many co-investment vehicles constitute alternative investment funds under AIFMD, requiring authorized management, risk controls, and regulatory reporting. Marketing rules have tightened since 2021, with stricter requirements for cross border offerings and reverse solicitation. For deal professionals, the main effect is longer lead times and more coordination with legal and compliance teams rather than major shifts in economic terms.
KYC and AML compliance create operational friction. Each co-investment SPV triggers separate onboarding processes. The US Corporate Transparency Act adds beneficial ownership reporting requirements, while EU and UK beneficial ownership registries require ongoing updates. These steps rarely kill deals but can delay closings if not started early in the signing to closing window.
Co-investments introduce specific risks beyond standard fund exposure. Adverse selection occurs when sponsors offer co-investments primarily for deals that breach fund concentration limits or have less obvious upside while retaining smaller, more attractive opportunities within the fund. LPs need to benchmark co-investments against the sponsor’s broader deal flow and fund level performance to avoid being the marginal buyer of risk.
Information asymmetry is structural. Co-investors rely on sponsor diligence with compressed timelines and limited data room access. They often cannot conduct full management Q&A or independent technical diligence. For junior team members, the practical implication is that your work is less about redoing the entire model and more about stress testing key assumptions around revenue growth, margin expansion, and leverage, drawing on best practices from M&A financial modelling.
Follow on capital creates recurring pressure. Portfolio companies frequently need additional equity for acquisitions, growth capital, or covenant cures. Co-investors face pro rata funding requests with limited negotiation time and the risk of dilution if they cannot participate. When screening a co-investment, teams should explicitly model follow on capital scenarios and document whether the LP has the capacity and appetite to fund them.
Exit misalignment can be costly. Co-investors typically cannot block exits timed to fund needs rather than asset optimization. This can trigger adverse tax consequences or suboptimal valuation outcomes for co-investors with different time horizons. In investment committee papers, it is worth flagging expected fund life, portfolio age, and any pressure on realizations that might drive early or late exits.
Operationally, co-investments require integrated cash management and administration. Capital call mismatches, unclear authorization processes, and administrator errors in distribution allocation create execution risk that can delay closings or misstate investor returns. Firms running multiple co-investments benefit from standardized workflows and clear sign off matrices to reduce these errors.
Finance professionals evaluating co-investments should apply explicit screens to avoid wasting time on unattractive opportunities. Key kill tests include sponsor economics misalignment, where sponsors have materially greater upside in the fund than the co-investment vehicle, suggesting incentive conflicts. Analysts can check this by comparing GP commitment, carry structures, and how much of the deal sits in each pocket.
Insufficient information access is a red flag. Sponsors that will not provide historical financials, key customer analyses, and a clear investment thesis with downside scenarios are asking co-investors to accept speculative risk without appropriate compensation. In practice, this often correlates with aggressive add on roll up strategies or sectors where value creation plans rely heavily on multiple expansion.
Unclear exit paths demand scrutiny. Assets dependent on narrow buyer universes, regulatory approvals, or uncertain IPO markets without realistic alternatives carry elevated risk, especially in volatile markets or rising rate environments. Co-investment teams should push for concrete exit cases, including sponsor precedent in the sector and current buyer appetite.
Follow on capital ambiguity creates open ended exposure. Co-investment documents granting sponsors broad discretion to call additional capital without clear limits or penalty structures for non participation shift risk inappropriately to co-investors. Structural complexity without commensurate reward is also a warning sign. Multi jurisdictional holding structures, opaque tax planning, and bespoke governance arrangements that deviate from standard LP protections may not justify modest fee savings.
Co-investment execution runs parallel to main deal processes with compressed timelines. Pre signing, sponsors build the investment case and identify potential co-investors based on internal allocation policies and LP relationship priorities. Between signing and closing, sponsors circulate co-investment materials under NDA while investors perform accelerated diligence, typically 1 to 4 weeks.
At closing, all elements converge: SPV formation, bank account setup, KYC completion, and capital funding. Any delays can jeopardize deal completion or force sponsors to fill equity gaps from other sources. Post closing, administrators onboard the co-investment SPV, establish capital accounts, and integrate quarterly reporting with main fund processes. This operational integration affects ongoing portfolio monitoring and exit execution.
Successful co-investors develop internal processes for rapid underwriting, minimal side letter negotiation, and acceptance of sponsor driven documentation. Those that cannot move at sponsor speed consistently lose allocations to more decisive competitors. For individual professionals, being able to build fast yet robust models, communicate key risks succinctly, and flag misalignment issues can be a strong differentiator in both private equity and corporate finance roles.
Co-investments occupy a middle ground between primary fund commitments and direct investing. Primary funds offer diversification and lower selection risk but carry full fees and limited asset selection influence. Direct investing provides complete control and economics but demands substantial internal resources for sourcing, execution, and portfolio management.
Separately managed accounts offer greater customization and control than co-investments but require higher minimum commitments and more operational infrastructure. Co-investments win when LPs want targeted exposure with sponsor level origination capabilities while accepting limited governance and information rights. For sponsors, co-investments complement continuation funds and net asset value financing in solving portfolio management challenges at both entry and later stages.
The strategic value depends on execution quality and scale. LPs with sufficient internal resources to underwrite quickly, realistic expectations about governance limitations, and disciplined approaches to sponsor selection can meaningfully improve net returns through selective co-investment programs. Others may find that the incremental complexity and risk offset the fee benefits.
Co-investments represent a valuable tool for improving portfolio efficiency and reducing fee burdens, but they are not free money. Success requires treating each opportunity as a full direct investment decision, maintaining rigorous standards for sponsor alignment and information access, and accepting the structural limitations that come with minority positions and compressed timelines. For finance professionals, mastering co-investment dynamics sharpens judgment on incentives, structure, and risk, and directly improves the quality of deal screening, modelling, and investment recommendations.
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