Economics of Co-Investments in Private Equity

A co-investment in private equity is a deal in which a limited partner (LP) invests directly alongside the general partner (GP) in a single portfolio company, rather than through the main fund vehicle. The economic appeal lies in reduced or waived management fees and sometimes lower (or zero) carried interest—but the trade-off is that co-invested capital often goes into the GP’s biggest bets and carries heightened concentration risk and potential selection bias.

Why GPs offer co-investments

A GP running a $5 billion fund may identify a blockbuster acquisition opportunity worth $2 billion. The fund can absorb it, but a GP eager to maximize LP returns and build deeper relationships with top-tier investors will often open a co-invest line so that major LPs can put capital directly into the company alongside the fund.

From the GP’s perspective, co-investments serve several purposes:

1. Larger check sizes: Instead of a single fund investment, the GP captures the LP’s full capacity in that single deal, deepening the relationship and increasing total AUM under management.

2. Fee arbitrage: The GP earns a higher return on co-invested capital because management fees and carry are lower or waived. The GP’s own co-invest stake sits alongside the LP’s, and both share in the upside. Because the GP avoids paying itself fees on co-invested capital, the net profit-on-investment is higher.

3. Alignment: Signaling to LPs that the GP is personally invested in the deal—and at the same terms as the LP—builds confidence. A LP is more likely to trust a deal if the GP is betting its own capital alongside, not charging layers of fees.

4. LP retention: In competitive fundraising, co-investment access is a draw for large institutions. Offering a regular co-invest pipeline helps retain top LPs when they might otherwise diversify to other GPs.

Fee structures: main fund vs. co-investment

A standard private equity fund charges management fees (typically 2–3% of committed capital per year) and carried interest (usually 20% of profits above a preferred return).

Consider a $5 billion fund with a 2.5% annual management fee and 20% carry:

• Annual fees: $125 million
• If the fund deploys capital over 5 years and achieves 4x gross MOIC (multiple on invested capital), carry on a $10 billion gain is $2 billion

A co-investment in a single $500 million acquisition often carries zero management fee and zero or reduced carry (maybe 5–10%). This means:

• An LP investing $50 million alongside the fund pays no annual fee on that co-invest capital.
• If the investment returns $200 million (4x return), the LP keeps the full $200 million minus any carried interest to the GP.

The economic comparison:

Over a 5-year hold, the co-investment saves the LP tens of millions in fees and carry—a powerful incentive.

Who gets co-investment access and why

Not all LPs can participate in co-investments. GPs typically reserve co-invest slots for:

• Mega-cap institutions: Sovereign wealth funds (e.g., Temasek, Canada Pension Plan Investment Board), large endowments (Harvard, Yale), and massive pension funds with billions to deploy.
• Anchor LPs: Institutions that committed the largest amounts to the main fund or that have a long relationship with the GP.
• Returning LPs: Investors in the GP’s prior funds, especially those with strong track records of follow-on commitments.
• Strategic partners: Corporate LPs, family offices, or other GPs seeking specific exposure or co-funding arrangements.

Mid-market and smaller institutions rarely have access to dedicated co-invest lines. A $100 million LP might be offered a chance to co-invest in one deal every few years; a $500 million LP might get regular opportunities.

The selection-bias trap

Here lies the hidden risk. Because GPs choose which deals to open for co-investment, there is a built-in selection bias: GPs tend to open co-invest lines for their highest-conviction deals or largest platforms—the deals most likely to succeed. Co-invested portfolios, when aggregated, often outperform the main fund on a gross basis.

However, this creates a statistical illusion. An LP evaluating a GP’s co-investment performance might see 4x or 5x returns across several co-invested companies, then assume that co-investing with that GP is reliably superior. But the GP was self-selecting winners. If the LP had instead co-invested in the GP’s 10th-best idea rather than the 1st-best, results would differ materially.

Additionally, co-investments introduce concentration risk. An LP’s $50 million co-invest in a single company is 100% correlated with that one bet. A portfolio-level downturn in the private equity market affects the co-invest just as severely as the main fund’s diversified portfolio—but with no diversification offset. If the portfolio company runs into operational trouble, the co-invested LP has no other holdings to smooth returns.

GP-led co-investments and secondary dynamics

A variant gaining popularity is the GP-led secondary or continuation vehicle. The GP offers existing portfolio company investors (often other LPs in the original fund) the chance to roll forward and co-invest in the next phase of growth, often with reset or extended carry terms. These arrangements can be attractive—extending an LP’s runway in a company it knows well—but they further concentrate exposure and can bury economic terms in complex cap tables.

Another model is sponsor-led co-invest funds: separate vehicles entirely focused on co-investments in the GP’s platform. These funds themselves charge management fees (though lower than the main fund) and offer carry, turning co-investment into a fee-bearing product line for the GP.

Tax and structural considerations

Co-investments may flow through the LP’s fund structure differently than main-fund stakes. The LP’s tax treatment, UBTI (unrelated business taxable income) risk for tax-exempt institutions, and consolidation accounting can all vary. A pension fund or endowment should model co-investment economics net of tax frictions before committing.

Benchmarking co-investment returns

LPs that participate in multiple co-investments should benchmark performance carefully. A reasonable test: do the co-investments outperform the main fund on a net-of-carry basis? If the main fund net return (after fees and carry) is 4x and the co-investment net return is 3.5x, the fee savings may not compensate for the lost diversification. Conversely, if co-investments return 5x+ net and main fund returns are 3x+, then the co-invest access has genuine value.

See also