E356: Why Co-Investments Are Taking Over Private Equity

0:00Rohan, you're at Hulohan Loki, which is a top boutique investment bank, and you focus on private equity co-investments. Why are there so many private equity co-investments happening in the market today? Taking a step back, it's helpful to frame this in the context of the market that co-investments are operating in. When you look at equity co-investments, this sits broadly within what we call directs, which includes direct equity, but also co-investments. And that market has experienced significant growth, particularly over the last five years, where it was in the 150 range back in 2021. and in 2025, trending well north of$300 billion annually.

0:31This is a market that's experiencing significant growth and has a lot of attention. When you zoom into co-investment specifically, this is a market that is in 2024, did well north of$30 billion, which was a peak and was trending to surpass in 2025. So continuing that momentum and definitely has a lot of attention. When you go into specific deal drivers for co-investment deal flow, I think there's three ways I think about that. Markets, GPs, and LPs. On the market side, we've seen a very extended time horizon for blind pool fundraising, many funds taking 18 to 24 months to close, particularly longer when you're a first-time or emerging manager.

1:05You couple that with extended time horizons for distributions, which is preventing LPs from committing again to blind pool funds. You have a lot of factors that are driving deal-by-deal fundraising and deal-by-deal execution. As funds have gotten larger, deals have also gotten larger. So the requirement for capital outside of what their fund can support has also increased. That's driving a lot of co-investment flow, even beyond what existing LPs that are in the funds can support. So you're seeing groups like us really benefit from that since we are working side by side with GPs who are looking to raise new third party co-invest capital.

1:37So it's kind of a perfect storm that's driving the deal flow. There's obviously a fee aspect to that where oftentimes co-investments are used to drive down fees, especially management fees. But there's more to it. Why are LPs trying to do more co-investments? What's behind that? Co-investments are now really being seen as a standalone asset class within private equity. So LPs are increasing their allocations specifically for this part of the market. And a big function of that is just really seeing the trend of outperformance over time, where, you know, individual deals through selection are, you know, oftentimes higher conviction and are generating, you know, stronger returns.

2:13Obviously, that's not a universal truth, but I think there's a lot of data to suggest that where a GP is highly convinced in a deal and is looking to raise capital, and this may be one that there's a lot of attention, I think that's a driver. But really from the LP side, it's also just the increasing sophistication. As programs have evolved, teams are becoming more adept in underwriting deals. And as a result, having those capabilities is driving kind of an internal focus on selection, where you're optimizing your portfolio, expanding, you know, where you have exposure to strategies or geographies or with different managers and assets.

2:43So it really does serve as now a tool to optimize a private equity portfolio for a program. Co-investments, there's different flavors of them. What are the different flavors and what's most attractive to LPs today? Where we look at co-investments, they come from either funded sponsors, oftentimes having committed funds with LPs, but we also are seeing them with independent sponsors. So groups that don't have committed pools of capital and operate in this model as either a way to build a firm or as a transition into a blind pool fund. So I think there is varying degrees of attractiveness across both those platforms.

3:17What we see is on the funded sponsor side, it's a lot more common and people are expecting it because it's something that's been used as long as private equity has been around. On the independent sponsor side, I think you're seeing more and more potential in that market. So there are growing numbers of very sophisticated investment professionals leaving blue chip pedigreed firms where they're now looking to set up something on their own, but are using that independent sponsor model as a transition to help build a track record of their own. And you're even seeing that some of those groups stay in that model longer or in perpetuity because of, you know, the advantages of operating this model.

3:52So when we think of co-investments, it can be various types of managers. But, you know, fundamentally, I think that the structure is very similar. And you referenced this blue chip managers doing these independent sponsored deals. McGraw-Woods just had a conference with 2 ,000 independent sponsors. I'm seeing people reach out to me every day, super blue chip people from Blackstone, TPG, KKR, etc. that are doing these independent sponsor deals. What accounts for so many blue chip sponsors being willing to go on their own and become independent sponsors? Over the last five years, particularly, this market has absolutely exploded.

4:27We've seen, I think, north of 1 ,400 independent sponsors now operating, which is double what it was in 2019. So growing number of people, what's important is how sophisticated and attractive those platforms are. That continues to grow every day. So I think what's really attractive about this model, and it's very similar to a co-investment model. These professionals are very experienced with this, having raised co-investment capital at their prior firms. But you're seeing, given kind of that pull from the LP side, where this is now something that's very in demand, you have the market conditions where this model is sustainable.

5:01And when you think about the GP side, there's a lot of advantages to operating without the kind of confines of a blind pool fund. You retain a lot of ability to be opportunistic in your deal selection within reason, of course, given LPs are looking to see you stay within your strike zone. But you also reduce a lot of the need right away to go and build a team because if you're a good deal professional and you have a good network, you can source deals. That's what people like to see early on in a funds kind of life cycle. But you also have a lot less of the administrative overhang from long fundraise and time before you can go out into market.

5:32There's a lot to be said about leaving a shop where you have a lot of momentum and hitting the ground running with deals on hand. And I've heard these crazy GP commit numbers for independent sponsors. Is it truly typical for a fundless sponsor to commit 5%, 10 % GP commitment to these deals? And where's the market like? Expert calls have always been one of the most powerful ways to build conviction. But today, investors are asked to cover more companies, move faster, and do it with leaner teams. With AlphaSense AI-led expert calls, their TGIS call service team sources experts based on your research criteria and lets the AI interviewer get to work.

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7:24Take advantage of AlphaSense AI-led expert calls now. The first to see wins, the rest follow. Learn more at alpha-sense.com slash how I invest. Five to 10 % is definitely what we see very often. And I think what LPs really like to see, you know, obviously you don't have the full track record to go and underwrite, especially if you're kind of doing deals one, two, and three. So you're looking to see conviction beyond what the track record from your prior firm may or may not be. GP commit shows a strong sense of alignment. There's a number of other factors that go into what makes a really good independent sponsor deal.

7:57but you know a lot of those look very similar to a co-investment process so you know do you have an inside track does it fit well within your strike zone of what your strategy is and you've executed on in the past that coupled with strong gp commit and kind of founder role and all those things together are important but yeah absolutely i think the the market for gp commit has moved up to that level and you take on just a small sliver single digit percentage of the deals.com on your desk what are you looking for as an intermediary to decide to spend your time working with an independent sponsor?

8:26We like to take the approach that we will take to market what we know LPs are looking for, because I think that's the strongest validator of deal is if we know that we have people in our network looking for something that looks like that. All that's to say, we take a very similar underwriting lens. So thinking about sponsor asset and structure of the deal. We are obviously working on transactions. So we're very much deal first. So, you know, thinking about is this a company that sits within a market that has good tailwinds? Is it a company that we can clearly identify merits to this investment and don't have immediate risks.

8:58Like, is there limited customer concentration, good geographic exposure, operating in a market that is growing and has tailwinds? So, you know, that's kind of the first, you know, avenue. Then you look at the structure, obviously, like, is this in a down market going to offer some sort of downside protection? We saw in 2023, 2024, a lot of groups starting to look for more credit-like instruments, preferred equity, things like that, where you have some sort of contracted return with some equity upside. So you have things like that, that helps the case for us to take on a deal when we're seeing 20 and can take on one.

9:30And then there's valuation that kind of goes coinciding with that. You know, are you paying a below market multiple? I think groups always like to see that GPs have an inside track. This deal's not widely shopped where there's not a ton of competitive tension. So you're getting it at a fair price that leaves room for expansion on the other end. And then the final piece of structure would kind of be, what is the economic proposal and governance look like? And co-investments, particularly with independent sponsors, you're seeing that people really are focused on that because they want to ensure the alignment and, you know, that they can contribute.

9:57And the last piece would be the sponsor element, which, you know, I think is where LPs historically have always focused. We look at, you know, the groups that have investment professionals that have very strong track records, like, were they able to take something with them from their prior firm and demonstrate success within their realm of expertise? Is it a team of three to four investment professionals with some operating resources? Or is it an individual or two that are just setting up shop. So, you know, we're looking for a lot of the things in that case that an LP would from a manager. When we last chatted, you told me some of the numbers and how big some of these co-investments get.

10:30Give me a sense for those numbers and who are the LPs that are investing these sums of capital. There's a very broad dispersion in deals. I think when you're working with some of the independent sponsors, you still see very high quality deals in that 25 to 50 million range. And I think that's intentional when you're building a firm. Your first deal, You don't want to go over your skis too much. You want to show that you can get the deal done, raise the capital. And oftentimes, if you're leaving a firm, you don't have the huge LP network right away. So you're still seeing a lot of those deals at that end of the market, and they're getting done.

11:00But over the last five and a half, six years that I've been doing this, we've seen that number really grow meaningfully. Like I've worked on co-investment deals that are north of a billion in equity. And these are with sponsors that don't have committed funds associated with that strategy. There is a little caveat there where some of these co-investment vehicles that are being raised for a deal that are significantly larger are being led by established managers that have committed funds. But, you know, we've also worked with independent sponsors that are doing deals that require$300 million to$500 million of equity.

11:27And I think that coincides with their growing institutional quality. There's a lot of independent sponsors that would love to do a deal that's$300 million to$500 million. What needs to be present for an independent sponsor to pull off a deal of this magnitude? You start with the sponsor quality and the track record. Have they done it before? If this is deal number one, and they don't necessarily have the track record to speak of, it's a little bit tougher. But if you've come from a blue chip firm, you've shown that you can raise and deploy large sums of capital, and then get to an exit on those transactions.

11:58That's like the first hurdle that a lot of independent sponsors need to cross. Then I think it really goes down to, again, how high quality is the asset? Is the valuation fair? But, you know, what does the package look like? Are you partnering up with an established manager that may take on, you know, 30 to 50 % of that equity. That helps an independent sponsor early on and gives a stamp of validation to a transaction where you're bringing on a partner that will help with that value creation, but also, you know, bring some of the capital and the infrastructure. For example, you might be a smaller partner, a smaller team.

12:31Let's say you even spun out of KKR, you still have a great relationship with KKR. KKR might lead or co-lead the deal and you might be doing a lot of the value add and helping and they'll carve out a chunk for you. Yeah, absolutely. Absolutely. That's a really good setup that we like to see with independent sponsors is where the capital may be spoken for from that larger partner, but you retain the ability to syndicate some of that down and you're really going to be the one driving the deal after close. That's some of the things that we like to see. I think obviously good deal dynamics, good relationship with the founder, proprietary track, attractive valuation, good structure, founder role.

13:02I think that's a strong show of alignment there where, you know, the founder or the management team of the business is rolling 20 to 30 % of their equity, staying on board. It shows continuity. It shows that you have the relationship and you're going to be able to work with them. Going back to your other question, who's investing in these, particularly within independent sponsors? And, you know, the aperture is a lot wider when you look at broader co-invest. But we've seen the market there go from predominantly family offices and, you know, SBIC funds and other private equity firms back in 2017 to 2019, where today you're seeing insurance companies, endowments, foundations, pension plans, sovereign wealth funds, all of the large allocators having sleeves of capital that are earmarked for co-investment transactions.

13:40And a lot of them do have reserves to go and do independent sponsored deals, you know, albeit in various forums where, you know, some of them are looking for a bit more of a seat at the table or ride shotgun alongside. I'm going to force you into a binary answer. So let's say you have 100 % or 100 points on deal that an LP is diligencing. How much of that is allocated to the deal itself and how much to the team behind it? For these groups that have very sophisticated underwriting platforms, when they're looking at the deal, they're thinking about what their role is going to be. So they know they're coming in as a partner and they're going to have 50 % of the equity.

14:16I think the deal becomes far more important and you're starting to see 60 to 75 % of those points going toward the deal because they know they're retaining some of that control and the ability to correct the ship if things go south. in a more traditional independent sponsor deal with a family office. I think the sponsor is incredibly important because in a passive role, you're taking the same approach as you would to putting money into a fund. You're banking on the manager to go and make the right decisions. So in that case, is it 50-50? Maybe is it 60-40 skewing to the sponsor? It might be somewhere in that range.

14:48That toggle is based on what the deal looks like and the structure is going to look like. said another way it's hyper rational both cases if you have a sophisticated partner worst case they end up having to do all the work they care a lot about the underlying deal as long as i guess the partner checks the boxes there's no no fraud no negligence no no really black marks on that team versus if you're a family office and you're looking for that team to drive it to provide the value add and make sure that the investment is ultimately successful you're going to be heavily underwriting the team the team is the party that's going to make sure that the investment is successful.

15:21Yeah, absolutely. Hit the nail on the head there. Continuation vehicles have now grown to, as of late, I think$110 billion. How big of the space are continuation vehicles? Where we look at directs, we see a lot of overlap with how folks are looking at single asset continuation vehicles and directs. I think there has definitely been over the last 10 years, a hyper focus on continuation vehicles, and that market has definitely exploded. So when we think about the overall pie of single asset equity, that piece today might still be, you know, relative to an independent sponsor transaction, a lot larger of, you know, the pie.

15:58But we're starting to see a lot more overlap. And especially from the LP perspective of how their programs can commit to both where, you know, for marketing a co investment, especially if it's kind of a midlife deal, looking to do an add on, it looks a lot like a secondary continuation vehicle. And you're Underwriting for a lot of the same attributes. A lot of these co-invest deals, whether with a dedicated capital pool or the independent sponsor, a lot of it starts on the deal, like you mentioned. Is the deal good? But there's also strategic considerations, both from the GP and the LP side. How can these co-invests lead to a longer-term relationship between the GP and LP?

16:36And how should GPs and LPs think about that in this context? The co-investment space is very much relationship equity driven. From the perspective of a GP, LPs who are equipped to provide co-investment advantageous, because as we mentioned, deals are getting larger as funds get larger. It's very likely that you're going to continually see the need for additional capital. And if you have LPs who are in your fund or in your network, it's a lot more efficient than going out and raising third-party capital. Granted, that process is becoming a lot more streamlined and we're doing it every day and seeing a lot of demand for products like that, which we love.

17:09But starting at that element, this is a relationship game. So from a GP perspective, it's always super helpful to have LPs who can do it. From the LP side, I think co-investments are still a great tool that you can use to get to know a GP. Similarly, when we talk to LPs, the best currency is always a deal. I think as GPs are getting to know LPs, the best currency is always a deal. Because especially for groups that have the capability to go and underwrite not only the sponsor, which is a legacy business, but also the transaction, you're really getting to see how a GP works and thinks and goes through their diligence and then will enact their value creation.

17:44If you can get there on a deal, there's no better way of underwriting a GP than riding alongside them for that transaction and understanding whether it is something that can develop into a longer term partnership. When you find something that just fits right, you end up wearing it more than anything else. And for me lately, that's been my rag and bone Miramar jeans. What really stood out to me is that they look like traditional denim, but honestly feel more like sweatpants. They've got that clean structured look, but with a level of comfort that makes them easy to wear all day. I've been wearing them pretty consistently, whether I'm recording, traveling, or just out there during the day.

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20:26Whether you're selling lattes, cutting hair, running a boutique, or managing a service business, Square helps you run your business without running yourself into the ground. I was actually thinking about this the other day when I stopped by a local cafe here. They use Square and everything just works. Checkout is fast, receipts are instant, and sometimes I even get loyalty rewards automatically. There's something about businesses that use Square, they just feel more put together. The experience is smoother for them and it's smoother for me as a customer. Square makes it easy to sell wherever your customers are, in store, online, on your phone, or even at pop-ups, and everything stays synced in real time.

21:01You can track sales, manage inventory, book appointments, and see reports instantly whether you're in your shop or on the go. And when you make a sale, you don't have to wait days to get paid. Square gives you fast access to your earnings through Square checking. They also have built-in tools like loyalty and marketing. Your best customers keep coming back. and right now you can get up to$200 off Square hardware when you sign up at square.com slash go slash how I invest that's sq u a r e.com slash go slash how I invest with Square you get all the tools to run your business with none of the contracts or complexity run your business smarter with Square get started today so let's go to venture how much of the venture ecosystem is driven by these co-investment deals and how do they differ from traditional private equity co-investments?

21:46Personally, haven't spent a ton of time on the venture space. I find it very interesting and think it's a very natural extension of what this product can do. But from conversations with several folks in that space, I think they really do operate on this model where they are raising capital deal by deal, especially early on as they're doing their first, you know, up to sometimes 10 or 15 deals. Some of the challenges of going and running a process for a venture product is the timeline. And I think the information that's often available, where if you're a venture investor and you understand the company and you have your buy box, it's a lot easier to understand and move on a quick timeline.