Private Capital Fundamentals: How and Why Co-investments Work

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Venture capital (VC) firms committed to generating optimal outcomes for their high-growth portfolio companies and community of investors typically engage a few different types of investment entities when funding their portfolio companies. Co-investments are one of the most common approaches VCs take to extend value in existing portfolio companies.  

As its name implies, a co-investment is a sidecar vehicle that typically invests alongside an anchor fund or another investment vehicle. VCs often use them to accelerate growth for a promising portfolio company, benefiting both the anchor fund’s and the co-investment's investment returns. In a co-investment structure, the VC remains the lead investor and opens a new entity to a group of existing and new LPs (Limited Partners). Multiple LPs then pool their resources into the new entity, putting capital directly into a single portfolio company.  

Benefits (and Drawbacks) of Co-investments

The structure of the co-investment approach is different than that of the traditional VC fund (“Fund”). Whereas a Fund invests in a portfolio of assets, diversifying risk and, in some ways, reward, a co-investment invests in only one company. In a co-investment, the investor gets all of the reward if the value of the business goes up and all of the risk if it goes down. Other differences between the traditional Fund and a co-investment often include the minimum required to invest, the potential time horizon of investment, and management fees.  

  • Minimum: Often, the amount raised for a co-investment is much smaller than that of a traditional Fund, allowing for smaller minimums.  
  • Time Horizon: Given that there is only one company in a co-investment entity and that one company has already been invested in at least once, the time to exit is often shorter than waiting for a basket of assets to each go through a liquidity event, as is needed in a Fund.  
  • Management Fees: For co-investments that are being offered because they aren’t good enough to meet the standard of a full follow-on investment from a Fund, it is common practice to set them up with a reduced fee. For those that are of the highest quality, investors should expect the same fees charged for their anchor fund investment.  

Investment Quality

A co-investment's direct access to high-potential startups is intriguing to many. That doesn’t mean that all co-investments are created equal. It is important to understand how a VC deploys their co-investment strategy. Historically, co-investments were used as a way for VCs to ‘sluff’ off lower-quality deals that did not warrant the remaining follow-on capital available in the anchor fund. That still occurs today, where a VC’s brand name, rather than performance, is used to raise additional capital for a portfolio company.  

However, more and more, top-performing VCs are offering access to their highest-quality investment opportunities through co-investments. These firms use these funding vehicles to put additional capital into companies that have proven their ability to grow after their anchor fund has invested as much as it can. When reviewing an investment opportunity, it is important to establish whether the underlying company is an early-stage startup with little traction and a fair amount of risk or a more mature opportunity where revenue is accelerating.  

Investor Alignment  

The different risk/reward balance between traditional, diversified funds and co-investments also make them more or less appropriate to different types of investors. For those who are prioritizing capital preservation and growing wealth more conservatively, a traditional diversified fund is likely the best investment approach. For those seeking to generate wealth more directly and who are willing to accept more binary risk, co-investment is a great option.  

Fundamentally, VC is an integral part of the innovation economy that can benefit everyone involved. That is why a network of committed investors is central to everyone's success. A good VC partner will consistently offer multiple ways for investors to participate, some with longer time horizons and more diversified risk and others that are more binary bets. Collectively, these investment vehicles are essential to the companies that are breaking through with needed solutions in their industry.

This article was originally posted on Forbes Digital.

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