Venture Capital Co-Investing with LPs: A Guide

The Rise of Nontraditional Investors in Venture Capital

Investing has become increasingly accessible for a wider range of individuals. Investors outside of conventional venture capital (VC) firms – known as nontraditional investors – are now significantly impacting the investment landscape.

Growth in Co-Investment Deals

Data from McKinsey reveals a substantial increase in co-investment deal value. Specifically, the total value more than doubled, rising to $104 billion between 2012 and 2018.

Estimates suggest that approximately 1,600 “nontraditional” investors participated in funding venture capital deals in 2021.

Motivations and Performance

The principal driver for these nontraditional investors is the pursuit of enhanced returns. Investing in conjunction with established VC funds presents a compelling avenue for achieving this goal.

A recent study conducted by Preqin demonstrates that co-investing funds consistently deliver superior performance compared to traditional funds.

Outperformance and Cost Benefits

Research indicates that a significant majority – 80% – of investors experienced higher returns from their co-investments than from traditional private equity fund investments.

Furthermore, 46% of these investors saw their co-investments outperform by a margin exceeding 5%.

A generally lower fee structure, when compared to traditional private equity or VC funds, also provides a benefit to co-investors.

Risk Sharing and Relationship Building

Sharing investment risk is another advantage of co-investing, creating benefits for all parties involved and fostering stronger investor relationships built on trust.

This investment approach often necessitates a more active role, allowing investors to collaborate closely with leading sponsors – the general partners (GPs).

Such collaboration cultivates deeper relationships and provides valuable insight into the GPs’ investment strategies and deal evaluation procedures.

Long-Term Investment Skill Development

For those new to the investment world, establishing these relationships is crucial for developing and refining their own investment expertise over time.

The Appeal of Alternative Investors to Venture Capitalists

The advantages of co-investing aren't exclusive to alternative investors; General Partners (GPs) also experience significant benefits. By collaborating with alternative investment sources, GPs expand their funding avenues and enhance their capital utilization for potential investments.

Venture Capital firms realize further advantages through this approach. While Limited Partners (LPs) participating in co-investments typically maintain a passive role, the VC retains voting control, safeguarding investor interests and streamlining the decision-making process.

This model also enables VCs to deploy greater capital into promising companies while adhering to established diversification guidelines.

Benefits for Portfolio Companies

This investment structure proves advantageous for companies seeking capital. Alternative investors provide additional funding without necessitating the introduction of another venture capital firm.

This is particularly appealing to founders who aim to limit the number of VCs and board members, as well as reduce the time commitment required for fundraising activities. Introducing an extra VC can often result in an unwieldy dynamic with too many stakeholders involved.

Furthermore, experience at C5 Capital has demonstrated that co-investors can evolve into valuable customers.

Optimizing Co-Investment Strategies

A substantial level of interest in this evolving approach is evident, yet not all entities possess the necessary expertise and assets to effectively implement a co-investment program. C5 Capital actively engages with alternative investors and has extended participation in over 50% of our transactions to external firms.

This has generated more than $80 million in co-investments within the past three years. We observe varying degrees of familiarity with co-investment structures among investors.

Some are already proficient, while others are initiating their involvement and require support. A comprehensive grasp of co-investment dynamics, alongside the requisite skills for success, is paramount for these investors.

Furthermore, a thorough understanding of the associated terms, potential benefits, and inherent risks is essential.

Consider these three key factors:

Due Diligence is Paramount

Due diligence is arguably the most important aspect of any investment, but it’s even more critical in a co-investment scenario. Investors must independently verify all information provided by the lead investor.

This includes a thorough review of the target company’s financials, market position, and competitive landscape. Don’t rely solely on the lead investor’s assessment; conduct your own independent analysis.

Alignment of Interests

Successful co-investments hinge on a clear alignment of interests between all participating parties. Ensure that the investment thesis, risk tolerance, and exit strategy are mutually understood and agreed upon.

Discrepancies in these areas can lead to conflicts down the road. Open communication and transparency are vital for fostering a collaborative relationship.

Governance and Control

The governance structure of a co-investment should be clearly defined upfront. This includes outlining decision-making processes, information rights, and dispute resolution mechanisms.

Investors should understand their level of control and influence over the investment. A well-defined governance framework minimizes the potential for misunderstandings and ensures accountability.

• Establish clear voting rights.
• Define information-sharing protocols.
• Outline procedures for addressing disagreements.

Co-investment can be a powerful tool for expanding investment reach and diversifying risk. However, it requires careful planning, thorough due diligence, and a commitment to collaboration.

By addressing these three considerations, investors can significantly increase their chances of success in the co-investment arena.

Understanding Investment Deal Terms

A comprehensive grasp of the investment’s terms is paramount initially. Data indicates that nearly half of sponsors waived management fees on co-investments back in 2015.

However, with heightened demand, the prevailing practice now sees most Limited Partners (LPs) compensating fund managers through both management fees and carried interest.

The specific fee structure is often determined by the co-investor’s method of participation – whether through a direct investment or via a special-purpose vehicle.

Management Fees and Carried Interest

Traditionally, a significant portion of sponsors opted not to levy management fees on co-investments. This trend has shifted considerably.

Currently, the expectation is that LPs will contribute to both the operational costs of the fund (management fee) and share in the profits generated (carried interest).

Investment Structure Impacts Fees

The way in which a co-investment is structured directly influences the applicable fees.

Direct investments may incur different fee arrangements compared to those channeled through a special-purpose vehicle, designed to isolate and manage the investment.

• Direct investments often involve a more streamlined fee structure.
• Special-purpose vehicles may introduce additional administrative costs.

Therefore, careful consideration of the investment vehicle is crucial when evaluating the overall cost.

Strategic Deal Selection

When assessing potential investment opportunities, it's crucial to maintain grounded expectations. The vast majority of companies will not achieve the explosive growth of a tech unicorn, therefore realistic exit strategies are paramount.

A significant portion of co-investors acknowledge that they are not seeking the next Uber, instead prioritizing smaller-scale investments. Data from ValueWalk indicates that 77% of Limited Partners (LPs) demonstrate a preference for small to midmarket buyout strategies, with co-investment amounts ranging from $2 million to $10 million.

Requesting and thoroughly reviewing the venture team's analysis, alongside access to the investment data room, is a prudent step. Co-investors can significantly benefit from the venture capital firm’s perspective and the results of their comprehensive due diligence process.

While valuation metrics are important, avoid becoming overly focused on the intricacies of the technology itself. Investors frequently become bogged down in technical details, diverting attention from fundamental aspects such as customer demand, market size, demonstrable product-market fit, the business model, and sustainable competitive advantages.

Direct Engagement with Leadership

Direct communication with the management team is highly recommended. This allows for a firsthand assessment of the company’s leadership qualities, the reliability of their projections, and their capacity for effective execution.

A critical evaluation of the team’s adaptability and resilience – their ability to foresee challenges and adjust accordingly – is essential. Ultimately, a company’s most valuable resource is typically its people, not its technology.

Evaluating Co-Investor Dynamics

Thorough due diligence of potential co-investors is crucial. When accepting investment alongside others, it’s important to assess their alignment with your company’s goals.

Co-investors often participate with smaller capital contributions. Consequently, it's vital to avoid being overshadowed, particularly by those who invested previously and may possess differing priorities.

Understanding Investor Rights and Influence

• Earlier investors frequently hold preferential rights.
• These rights can include superior voting power.
• Board control is another potential area of influence for established investors.

Carefully examine the terms of previous investment rounds. This will reveal the extent of control existing investors wield.

Alignment of incentives is paramount. Discrepancies in vision or exit strategies can create friction later on.

Protecting your company requires a clear understanding of the power dynamics at play. Don't hesitate to seek legal counsel to review investment agreements.

Potential Risks of Misaligned Investors

Being outvoted on key decisions can hinder strategic direction. A lack of shared vision can lead to conflicts and impede growth.

Ensure new investment doesn't disproportionately benefit earlier stakeholders at the expense of the company’s long-term health.

Proactive Steps for Investor Assessment

Investigate the co-investor’s track record. Understand their investment philosophy and typical involvement in portfolio companies.

Directly discuss expectations with potential co-investors. Open communication can reveal potential conflicts before they arise.

Concluding Remarks

The inherent benefits of co-investing explain the increasing interest from numerous institutions. Investment performance remains robust, and the availability of potential opportunities is expanding. However, investors initiating co-investing strategies without sufficient expertise may encounter unfavorable outcomes.

A comprehensive grasp of both the potential risks and benefits associated with co-investing is paramount. Through careful consideration of deal structure, astute deal selection, and thorough due diligence, co-investors are well-positioned to enhance their overall returns.