For some limited partners, smaller co-investment deals are better.
According to a new survey from Stifel Financial and Eaton Partners, 55 percent of respondents said the sweet spot for direct co-investments is between $5 million and $10 million. The same portion said the ideal size for a co-investment was slightly larger, between $10 million and $20 million.
Co-investments have swelled in popularity in recent years, as investors look to leverage their pools of capital to gain transparency into portfolio companies and cut back on the fees they have to pay to managers.
“I have sensed from people that they want to be meaningful, they want to feel that they’re part of a deal,” said Peter Martenson, global head of Eaton’s GP advisory, secondaries, and directs practice.
He believes that investors expect to commit about 10 to 15 percent of the total co-investment transaction. Institutions want their investments to be “a meaningful part — but not too meaningful — of the transaction,” Martenson added.
According to Martenson, the 47 survey respondents were primarily a mix of family offices and asset managers that act as LPs via their fund-of-fund strategies. They are by-and-large based in North America and Europe.
In addition to polling respondents on their expected transaction sizes, Eaton Partners also sought information on the portfolio companies these co-investors want to target.
From a sector perspective, both business services and healthcare companies are hot commodities, each with 70 percent of respondents saying that they preferred these industries.
“People feel that there’s an industry tailwind,” Martenson said. In healthcare, there are strong organic growth rates driven by aging populations. There’s also a fair bit of clarity on what healthcare providers can expect to get paid, Martenson said.
In business services, margins are high, and it’s easy to ink bolt-on transactions that can help improve an asset’s revenue, he added.
Investors are usually targeting between $10 million and $30 million in EBITDA, and are most likely to target companies worth between $150 million and $250 million overall.
“The world has learned that it’s easier to double and triple revenue for a $200 million enterprise value company versus a $2 billion company,” Martenson said.
In terms of structuring the fees on these co-investments, the majority of respondents said they either use a multi-tiered carry structure or a 10 percent carry over an 8 percent hurdle. Overall, they are lower than the typical 2-and-20 deal an LP would get by investing in a private equity fund.
Co-investors are also asking for certain deal terms that would protect them in the event of collapse. Seventy-two percent of respondents said they usually require “drag-along” rights, which are provisions that allow investors to force a portfolio company sale after a certain time period, should they need to. Meanwhile, 49 percent require “negative covenants,” which could prevent the company from buying or selling assets without board approval.
“They don’t want to have ‘control’ or be in the drivers’ seat,” said Martenson. But “they have some covenants that if things go sideways, they have the right to have more control and say. It’s signaling to the independent sponsors that you’ve got the wheel as long as things are going well.”
