How VCs can get the most out of co-investing alongside LPs

It has rarely been easier for people looking to invest. Nontraditional investors, which include anyone outside of traditional VC firms investing in venture capital deals, are increasingly making their presence felt in the investing community.

McKinsey found that the value of co-investment deals has more than doubled to $104 billion from 2012 to 2018. And by some counts, there are as many as 1,600 “nontraditional” investors helping to fund venture capital deals in 2021.

The primary motivator for nontraditional investors is seeking better returns, and investing alongside VC funds is a great way to achieve that. A recent Preqin study shows co-investing funds significantly outperform traditional funds.

Research shows that 80% of investors found their co-investments outperforming private equity fund investments, with 46% outperforming by a margin of more than 5%. Investors also benefit from a generally less expensive fee structure compared to traditional private equity or VC funds.

Co-investors can also profit by sharing the investment risk, which benefits all investors and builds loyalty and trust. And because this kind of investing requires a hands-on approach, investors get the chance to work closely with top sponsors — the general partners (GPs) — to foster deeper relationships and gain a better understanding of the GPs’ investment strategies and deal review processes. For new investors, building these relationships is essential for strengthening their own investment skills in the long run.

Why VCs love alternative investors

Alternative investors aren’t the only ones who benefit from co-investing, it’s also a boon for GPs. They gain a broader array of funding options by partnering with alternative investors, and they can leverage their own capital more effectively with prospective investments.

VCs have other benefits too: While co-investing LPs remain passive in the business, the VC can use that voting power to preserve investor rights and consolidate decision-making. It also allows them to put more money to work in any company while staying within diversification limits.

Companies can thrive with this investment model as well. An alternative investor infuses more funding without bringing another VC to the table. That’s good news for founders who want to minimize the number of VCs and seats around the board table as well as time spent fundraising. Adding an additional VC often leads to a scenario where there are too many cooks in the kitchen. In our experience with our fund, C5 Capital, some co-investors have become customers.

How to get co-investment right

It’s clear there is significant interest in this new paradigm, but not everyone has the skills and resources required to successfully execute a co-investment program. At C5 Capital, we welcome alternative investors and have opened up more than half our deals to outside firms, resulting in more than $80 million in co-investments over the last three years alone.

We’ve found that some investors are well versed in co-investing arrangements, but others are just starting out and need some guidance. It’s critical that these investors understand both the dynamics of co-investing and the range of competencies required to be successful. In addition, they need a solid understanding of the terms, upsides and potential downsides.

Here are three important considerations:

Know the deal terms

The first step is to fully understand the investment terms. Almost 50% of sponsors did not charge any management fee on co-investments in 2015. However, as a result of increased demand, the majority of LPs today pay a management fee and carried interest to the fund manager. The fees typically depend on whether the co-investor makes a direct investment or invests via a special-purpose vehicle.

Choose deals wisely

When evaluating deals, keep in mind that most companies are not going to be the next tech unicorn, so set realistic views on exits. Most co-investors realize that they are not likely to be investing in the next Uber and are pursuing smaller deals. According to a study by ValueWalk, 77% of LPs preferred small to midmarket buyout strategies and $2 million to $10 million per co-investment.

It’s wise to ask for and review the venture team’s analysis as well as the investment data room. Co-investors can benefit from the VC’s view and extensive due diligence findings. Ask for valuation metrics, but don’t sweat the technology. Too often, investors get mired in trying to understand technology specifics instead of focusing on the fundamentals: Customer demand, market size, evidence of product-market fit, business model and sustainable differentiation.

Talk to the management team directly. Get a feel for the company’s leadership, the certainty of their forecasts and their ability to execute. Take a hard look at the team’s resilience and their ability to anticipate and adapt. People, not technology, are typically a company’s most important asset.

Kick the other investor’s tires

Make sure to study the investor alignment. Co-investors come in as smaller players, so make sure not to get trampled, especially by earlier investors who may have different incentives and higher voting rights or board control.

Final thoughts

Given the attractive features of co-investing, it is understandable why many institutions are pursuing it. Performance continues to be strong and investment opportunities are growing in number. That said, investors who begin co-investing without having the requisite knowledge of what it takes to be successful are likely to be disappointed with the results. Developing a full understanding of the risks and rewards of co-investing is an essential first step. With the right deal structure, deal selection and deal investigation, co-investors can significantly increase their returns.

How to identify unicorn founders when they’re still early-stage