Fee Breaks, Deconstructed

As more LPs jump on the co-investing bandwagon, the question arises: how do you quantify the benefit of direct investments for an LP’s private equity portfolio?

A handful of studies have taken a look at historical performance for private equity fund investing versus PE direct/co-investing. However, these studies are typically plagued by survivorship bias, as well as the evolution in economics for both funds and co-investments throughout the last three decades.

To keep things simple, yet useful, Privcap has calculated the structural impact of co-investment allocations on a PE portfolio. Among the assumptions we make are that the funds and no-fee co-investments have the exact same gross returns, so deal selection is not at issue. In fact, we note in our key observations below that the fee savings from co-investing provide LPs with a substantial margin of error when selecting co-investment deals. However, we do not take into account the costs of accessing co-investments, be it by investing in an internal team or hiring a funds-of-funds or PE advisor.

The analysis below is based on the following assumptions:
• $100M aggregate portfolio size
• Underlying portfolio companies of both funds and co-investments generate returns of 2.0x gross TVPI
• Fund economics: 2 percent p.a. management fee, 20 percent carried interest, 8 percent hurdle rate, 5-year investment term
• Co-investment economics: No fee, no carry (and thus no hurdle rate), 5-year investment term

Estimated Performance and Fees Based on Fund vs. Co-investment Allocations

Key Observations:
• A portfolio that invests only in funds will achieve a net annualized return that is nearly 300 bps lower than a portfolio that splits its allocations evenly between funds and co-investments. The latter scenario results in a fee savings of almost 60 percent in dollar terms.
• A co-investment-only portfolio has a 515 bps advantage on an annualized basis over a funds-only portfolio, and is not subject to fees or carry.
• Based on our assumptions, a co-investments-only portfolio can underperform the same investments in a funds-only structure by more than 20 percent cash-on-cash and still achieve the same net IRR.
• In a portfolio of 50 percent funds – 50 percent co-investment/directs, the co-investment/directs can underperform the funds’ performance by 24 percent cash-on-cash and the overall performance of the portfolio would be equivalent to that of a funds-only portfolio.