Private equity assets under management are growing at a healthy clip, but increasingly through co-investment deals and other non-traditional arrangements. Fund raising for traditional blind pools managed by PE specialists has grown tougher, as reported, leading some market participants to wonder when some of the new types of structures could fail.

Limited partners (LPs) – that is, investors – have grown more keen on entering direct deals in alignment with their general partners (PE fund managers) than investing in the funds themselves, partly as a means of reducing GP fund fees.

Juan Delgado-Moreira, managing director at private markets manager Hamilton Lane, said that 80% of the firm's LPs wanted to do more co-investing. "No GP will admit to not being ready to do it," he added. "It’s too much; there will be casualties.”

He was speaking at a recent conference organised by the Hong Kong Venture Capital and Private Equity Association, where co-investing was a hot topic among GPs and LPs alike.

The numbers explain why: whereas in 2014, global PE firms raised $2.8 billion for co-investments, they raised a whopping $10 billion in just the first nine months of 2015, said Hemal Mirani, managing director at HarbourVest Partners.

The trend, she said, stemmed from LPs' desire to reduce fees and to use co-investments to test-drive a GP before making more substantial commitments to a fund.

But co-investment seems to be taking on a life of its own.

“The emerging trend among LPs is to bypass the GP structure,” said Huh Yonghak, founder and CEO of First Bridge Strategy, an adviser to LPs’ alternative investment programmes. LPs now favour club deals (investing as a consortium involving GPs and LPs), direct deals (excluding GPs) or co-investing into deals alongside capital from a GP’s fund.

Huh said the co-investment trend emerged from the aftermath of the 2008 global financial crisis, when the balance of power between GPs and LPs shifted to favour the investors, because many GPs found themselves desperate for capital. The crisis may have passed, but LPs have developed a taste for flexible structures. “GPs can’t ignore this,” Huh said.

“It’s about alignment of interests,” said Ralph Keitel, Singapore-based principal investment officer for the International Finance Corporation (IFC), the private-sector arm of the World Bank.

LPs such as the IFC and its co-investors make large commitments to a fund, perhaps as much as $100 million, which involves paying a 2% management fee on that money, but not all of it may be called or swiftly deployed. “You’re paying a lot for money that doesn’t get used,” Keitel said of traditional GP funds.

Eric Solberg, founder and CEO of EXS Capital, said his business only co-invested, mixing its own money with those of institutional or high-net-worth clients. The challenge is to make sure the economics continue to reward the GP. “The secret is to figure out where the roles really are, and how to align interests,” he added.

Delgado-Moreira said co-investment had exploded over the past year with new portfolio strategies. Once the domain of pure buyouts, it has morphed to include venture capital and private debt. But this proliferation is also creating confusion, he said: “Who bears the transaction risk? Who shares the cost? Or is it a syndication risk?”

Some LPs or their advisers may have a track record of picking the best GPs, which at least offer a fairly uniform set of structures and means of measurement. There is no evidence that even sophisticated LPs are better at picking direct investments than at selecting GPs. Moreover, the diverse nature of direct investments, regardless of whether there is GP “skin in the game”, adds to the complexity.

Indeed, the very amount of capital that has shifted terms in favour of LPs is their Achilles’ heel: the need to deploy it creates new constraints and limits their choices. That is guaranteed to lead to some disastrous co-investments, suggested Delgado-Moreira. 

“A few deals that are widely held [among multiple LPs] will go bad, and co-investing will get a bad name," he noted. "Within the next five years, they’ll stop calling it ‘co-investing’.” He didn’t say what else it might get called.