When San Francisco-based Generate Capital earlier this year agreed to provide $200 million in credit to build an electric arc furnace steel mill near Mojave, Calif., it brought along for the ride pension funds not only from California, but from Australia as well.
In the first deal under its new strategic credit strategy, the $353 billion CalSTRS pension fund and Australia’s $91 billion HESTA co-invested with Generate to help Pacific Steel build one of the first green steel plants west of the Mississippi. The plant is expected to convert scrap steel to construction rebar with 85% lower carbon emissions than other production methods.
Pension funds increasingly are writing big checks for sustainable infrastructure and other projects alongside their fund managers who arranged the deals. Such “co-investments” have moved from the sidelines to the center of fundraising for private equity and debt funds and other investment vehicles, as institutional LPs push their fund managers for more access to direct investments – and for lower fees.
“When you’re raising a fund these days, a key consideration for some LPs is how much co-investment you are expected to be able to give them,” Generate’s Scott Jacobs told ImpactAlpha. In the case of Pacific Steel, it had taken Generate roughly two years to put the deal together. Nonetheless, it offered CalSTRS, HESTA (for Health Employees Superannuation Trust Australia) and other investors in its credit fund the chance to make an additional low-fee investment.
“They see it as an investment opportunity that they find attractive, and they wanted more of it than they were going to get through us otherwise,” Jacobs said.
Co-commitments
More than $33 billion was raised last year across only 40 co-investment vehicles, according to PitchBook.
From early stage VC through growth-stage private equity and across the private-credit and infrastructure markets, general partners have had to accommodate themselves to the fact that their deep-pocketed limited partners want to piggyback on their best deals without paying full freight on fees.
Depending on their negotiating clout, fund managers are forgoing big chunks of the management fees and carried interest, or share of a deal’s profits, that GPs would typically get for sourcing the transactions in the first place.
CalSTRS estimates its co-investment strategy saved $245 million in fees and carried interest in 2022 alone. Its California sibling, CalPERS, estimates that over the life of a $1 billion co-investment, it saves approximately $400 million in management fees and carried interest it would otherwise have to pay. CalPERS is deploying nearly half of its private equity portfolio as co-investments.
In some cases, such no- or low-fee co-investments make up the bulk of funds raised, even for private equity giants like TPG. In its most recent quarter, TPG faced challenges with fee-related earnings, which it said would decline early this year before rebounding.
“As I’m sure you know from all the LPs in the industry, delivering co-invest is kind of table-stakes to their view of relationships,” TPG’s Jack Weingart told analysts after the $246 billion private equity firm released its quarterly earnings last week. Most of the funds that the firm recently raised for its flagship capital platform came in as co-investment commitments, he said. “Every quarter, we will have a portion of our capital-raising in no-fee, no-carry, co-invest vehicles.”
Fee fatigue
For many institutional investors, the fee structure of traditional “2 and 20” private equity funds – fund managers typically charge an annual management fee of 2% of assets, and expect 20% of the profits – has long felt onerous. In 2020, CalSTRS’ Chris Ailman’s 10-year forecast projected annual portfolio costs would rise to nearly $1.8 billion before the end of the decade.
CalSTRS “collaborative model” sought to cut such expenses by investing directly, rather than going through its fund managers, whenever possible. Under its new chief investment officer, Scott Chan, CalSTRS now manages more than 60% of its portfolio internally, and estimates that the collaborative model has saved at least $1.6 billion so far.
“Although global private equity deal volume has declined in recent years, demand for LP co-investment opportunities is booming,” the law firm Cleary Gottlieb wrote in a recent report, citing a survey that found that two-thirds of limited partners plan to participate in private equity co-investment opportunities in the next year.
One party’s lowered costs are another party’s foregone revenues.
“There are folks who want to put $5 or $10 into co-investments for every dollar in the fund, because there’s no management fee weight, and they can pick and choose which deals they do, which ones they really like,” said Neil Devani of Necessary Ventures, which has made more than 20 investments from its first fund for early-stage, mission driven tech companies.
Early stage funds can often reserve room for their limited partners in future financing rounds, even if they don’t participate themselves. Such deals don’t generate fee revenues, though in Necessary’s case, the firm does retain its carried interest.
“For us to have a business, to bring those opportunities, we have to have a fund,” Devani told ImpactAlpha. “So there’s some balancing that goes on between what someone’s investing in the fund and the allocations they get on a co-investment basis.”
Funds of funds have been particularly aggressive in pressing for fee concessions because of LP concerns about the stacked fees of two levels of fund management. In addition to insisting on co-investment rights, some also insist on taking “GP stakes” in the fund management business itself.
Access to capital
Some general partners comfort themselves that they might never have collected fees on that co-investment capital anyway. Institutional LPs are constrained by concentration limits that may prevent them from a bigger investment in the fund itself. And the ability to bring along more capital from institutional co-investors can help fund managers win deals. Co-investments may also lower the cost of capital for their portfolio companies, particularly as interest rates remain high.
General partners have to make such co-investment opportunities available to all general partners on an equal basis. A 2023 rule change from the Securities and Exchange Commission required managers to disclose any preferential treatment extended to fund investors and to share any side letters with particular LPs.
As a manager of funds of funds, Illumen Capital has the opportunity both to co-invest with the managers in its portfolio, and also to make co-investment opportunities available to its own limited partners. Illumen seeks to unlock value by helping managers eliminate explicit and implicit biases in their portfolios, as well as in their own investment processes.
“Our LPs are invested in us because we’re discovering funds that are overlooked by much of the market,” says Illumen’s Daryn Dodson. “They have lots of opportunities to look at the rest of their investments differently, and how they might move into funds they’ve been exposed to through our research.”
Illumen itself has co-invested with one of its managers in a company that Dodson says was overlooked by a number of Silicon Valley venture firms that didn’t have experience underwriting companies led by Latina founders. “The fund manager that we partnered with had deep experience in investing in women and women of color, being a women-led firm, and executed an investment that we are continuing to be excited about.”
Generate’s Jacobs in January penned an “open letter” to climate and carbon-transition investors, urging them to get on a war footing for the new policy environment. He advised raising multiple types of capital and keeping focused on customers “who are not looking back on decarbonization, resilience, and cost savings measures.” In addition to its $10 billion balance sheet and private-credit funds, co-investment is a growing part of Generate’s capital stack.
HESTA, the Australian pension fund, also participated in Generate Capital’s first co-investment deal, along with the Healthcare of Ontario Pension Plan, or HOOPP. Generate first provided $500 million to Pine Gate Renewables in Asheville, NC, a developer and operator of utility-scale solar and storage projects, in June, 2022. Last year, that was increased to $650 million with participation from HESTA and HOOPP.
“We put more money in, and we brought more money from others in to help scale Pine Gate, because they’re growing so fast and doing incredible, really good work,” Jacobs said. “Co-investment is a great tool for investment firms to manage portfolio construction and scale their access to capital. And it’s a great tool for the asset owners to be able to reduce the costs of their investment portfolio.”
He declined to disclose Generate’s co-investment fee structure, but said, “We wouldn’t do it if we didn’t get paid for it.”
