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What are the Implications of Fee Free Co-invest?
Why LPs Need to be Aware of this Phenomenon
Matthew Podlesak
June 20, 2024
Co-investments are an important phenomenon that LPs of all sizes need to keep in mind.
TLDR Part I:
Mega-LPs like CalPERS care a lot about fee free co-invest because it has a significant impact on returns.
By CalPERS math… deploying 40% into fee free co-invest and 60% into funds with fees:
1. increases Net MOIC by ~0.2x
2. Reduces annual management fees by 50bps
3. Reduces carried interest by 350bps
4. Will save them $25 billion on the next $150 billion they deploy into PE over the next decade
This means that CalPERS will view:
- a manager who delivers a 2.7x Gross MOIC and 2.3x Net MOIC and charges full fees the same as
- a manager who delivers 2.5x Gross MOIC and 2.3x Net MOIC and gives 40% fee free co-invest
TLDR Part II:
But why do I care? I’m an individual investor and I’m not deploying $15 billion per year into private equity. I don’t get any co-invest.
You should care because all of this co-invest creates NOISE.
This is the noise around which PE funds are “hot”, which PE funds are liked by big institutional LPs, etc.
If you’re paying full freight fees… you’re going to want the manager who delivers the best gross returns.
Not the manager who gives mega-LPs the biggest co-invest allocations to attract their capital.
Co-invest - what’s the big deal? We’re talking serious dollars here… for CalPERS… $25 billion of savings on fees over 10 years
Last week, CalPERS had an Investment Committee review of their private equity portfolio (link)
CalPERS laid out how they want to save $25 billion worth of fees via co-invest over the next decade by targeting 40% of their PE investments as co-investments
This is $25 billion of fee savings on $150 billion deployed
First - what are co-investments?
When an LP invests with a private equity firm, the standard investment is into a fund
This fund then goes and invests into underlying portfolio companies
The LP will have exposure to all of these portfolio companies in the fund
A co-investment (“co-invest”) is the opportunity for a limited partner to invest directly into a portfolio company deal alongside the private equity fund
Under this structure, the LP is directly invested in the company outside of the private equity fund structure
Because of this, the Private Equity GP is able to give LPs access to these co-invest deals on a fee free basis
This means the LP does not need to pay the traditional 2&20 (2% annual management fee / 20% carried interest performance fee)
This has huge implications for LPs…
Second - how do we quantify the impact of co-invest on LP returns?
CalPERS laid out their own math below
CalPERS expects to deploy $15.5 billion per year for the next 10 years into private equity
Every $1 billion they deploy into co-invest saves them $400 million in management fees and carry (vs. paying full freight fees on the $1 billion)
Third - lets double click ourselves into CalPERS math to understand the impact on returns
CalPERS wants to deploy 60% into the funds and 40% into fee free co-invest.
Co-invest has the following impact on a $15.5 billion commitment:"
1. Saves 50bps on management fees, reduced from 1.25% to 0.75%
2. Saves 350bps on carried interest fees, reduced from 20% to 16.5%
3. Improves the Net MOIC from 2.10x to 2.26x
4. Saves $2.5 billion on fees on the $15.5 billion invested
5. Raises “implied” Gross MOIC on the 40% co-invest manager from 2.5x to 2.7x
These are not small dollars and its clear how these incentives can have a significant impact on LP decision making.
All of a sudden, a GP that delivers a Net MOIC of 2.10x and offers co-invest is “equivalent” to a GP who delivers a 2.26x Net MOIC with no co-invest… in the eyes of the LP.
CalPERS will view:
- a manager who delivers a 2.7x Gross MOIC and 2.3x Net MOIC and charges full fees the same as
- a manager who delivers 2.5x Gross MOIC and 2.3x Net MOIC and gives 40% fee free co-invest