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

Article originally published in TechCrunch.

​By some counts, there are as many as 1,600 “non-traditional” investors helping to fund venture capital deals in 2021. Non-traditional investors include anyone outside of traditional VC firms investing in venture capital deals.
 
The non-traditional investment field is booming. McKinsey found that the value of co-investment deals has more than doubled to $104 billion from 2012 to 2018. That upward trajectory is likely to continue.
 
The primary motivator for non-traditional investors is seeking better returns and it’s proving successful. A recent Preqin study shows co-investing funds significantly outperform funds that don’t co-invest. Research shows that 80% 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 lower expensive fee structure compared to traditional private equity or VC funds.
 
Co-investors can also profit by sharing the investment risk, a win for all investors that builds loyalty and trust. Because co-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 GP’s investment strategies and deal review processes. For the co-investor, 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. The trend toward co-investing is also a boon for the 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.
 
There are other pluses for VCs. 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.
 
What are the benefits for companies?
Companies can thrive with co-investment 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 inevitably often leads to too many cooks in the kitchen. And in the case of our fund, C5 Capital’s, we have brought in co-investors who have become customers.
 
How to get co-investment right
It’s clear there is significant interest in co-investing, but not everyone has the skills and resources required to successfully execute a co-investment program. At C5 Capital, we welcome co-investors and have opened up more than half our deals to outside firms. That has resulted in more than $80M in co-investments over the last three years alone.
 
We’ve found that some co-investors are well-versed in co-investing arrangements; others are just starting to co-invest and need some guidance. It’s critical that co-investors understand both the dynamics of co-investing and the range of competencies required to be successful. In addition, co-investors need a solid understanding of the terms, upsides, and potential downsides. For those new to co-investing, here are three important considerations:
 
1.     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 (sidecar) vehicle.
 
2.     Choose deals wisely
When evaluating deals, keep in mind that most are not going to be the next tech unicorn so set your own realistic view 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 from ValueWalk, 77% of LPs preferred small to mid-market buyout strategies and $2 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, versus 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.
 
3.     Kick the other investor’s tires
Make sure to look at 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.
 
A final thought
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.
 
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About William Kilmer
William Kilmer is Managing Partner with C5 Capital, a venture capital fund investing in the secure data ecosystem. He currently sits on the board of five companies in the US and UK. He was formerly an Operating Partner at Mercato Growth Partners and has served as a CEO and CMO on three companies. He previously worked as the Managing Director for venture capital investor Intel Capital Europe, based in London. His new book, Transformative, will be published 2021.