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Smaller GPs offer LPs co-investments to build trust

GPs, particularly those in the lower middle market, use co-investments as a way to establish LP relationships—an otherwise challenging feat given the lethargic fundraising environment.

Butterfly Equity, a Los Angeles-based PE firm that focuses on the food sector, uses co-investments in the majority of its deals as a way to get them inked, build trust with new limited partners and lock down capital in future fundraising.

“For us, it’s been a great way to meet investors,” said Butterfly co-founder and co-CEO Dustin Beck. “Even if they ultimately don’t end up investing into a particular deal, they at least get to see how we run diligence and our what our criteria is for a good deal.”

GPs, particularly those in the lower middle market, use co-investments as a way to establish and solidify relationships with LPs—an otherwise challenging feat given the lethargic fundraising environment. In fact, 86% of PE deals involving co-investors in 2023 have fallen below the $500 million mark, according to PitchBook data.


Butterfly Equity bought an ownership stake in Qdoba from Apollo Global Management in 2022 with a co-investment from hedge fund King Street Capital Management. Butterfly Equity merged the Mexican fast casual restaurant chain with portfolio company Modern Restaurant Concepts.

In another win, the firm acquired a majority stake in Orgain, which makes products including protein powders, with a co-investment from the Ontario Teachers’ Pension Plan in 2019. OTPP gained a minority stake.

“When we started—it’s hard to raise a first-time fund, right?—so we were most focused on finding really interesting deals,” said Adam Waglay, Butterfly Equity’s other co-founder and co-CEO. “And then using those deals to convince people to invest in the fund and to get to know us better.”

This year, the firm employed the help of another co-investor on an infusion of growth capital into one of its portfolio companies, a farm and distributor of striped bass called Pacifico Aquaculture.

The incentives

Fund managers hope to “sweeten the pot” for their investors by offering co-investment opportunities, said Scott Reed, co-head of private equity at HighVista Strategies, a lower-middle-market firm that acts as a co-investor on specific deals.

For the LP, these arrangements can offer lower fees, increased control of the target company and a lower risk-return profile. Rather than paying high fees on commingled funds, co-investments allow investors to pick and choose individual direct investments.

At the same time, the LP typically has more insight into operations at the target company than it would have as a stakeholder in a commingled fund, thus reducing a certain amount of risk.

“Investors get to pick their risk profiles,” said Waglay. “Let’s say they invested in your fund but they like one deal a whole lot more than some of the other stuff in the fund. [Through a co-investment] they can adjust their risk-return appetite, like a choose-your-own-adventure.”

What’s more, co-investments are a backdoor way to rope in LPs without changing the fee rate charged on fund commitments, Reed said. This means GPs can maintain typical fees and carry percentages on their traditional fund offerings while broadening their appeal with low- and no-fee offerings like co-investments on the side.

The attractiveness of co-investments is, in part, a product of a difficult fundraising environment. US PE middle markets have fared well compared to mega-funds and emerging managers, but they are not insulated from capital-constrained LPs.

From H1 2022 to H1 2023, capital raising across all strategies fell 30.9%, according to PitchBook’s Q2 2023 Global Private Market Fundraising Report, and the middle market managers are taking longer to close funds. In the first half of the year, PE middle-market funds took an average of 15.4 months to close, a 2.1-months longer than 2022’s average, according to PitchBook’s Q2 2023 US PE Middle Market Report.

‘More aggressive’ co-investment terms

Still, wider market headwinds that have led to limited distributions and a shallow supply of institutional capital are also inhibiting co-investment opportunities.

In 2022, lower-middle-market PE co-investment deal value fell slightly from its 2021 peak of $22.8 billion total to $19 billion, according to PitchBook data. So far in 2023, that number is hovering at $9.5 billion.


LPs—aware that their capital is scarce—are requesting more favorable terms in co-investment deals in the form of stronger information rights and more control over decisions made about the portfolio company, said Matthew T. Simpson, co-chair of the private equity practice at law firm Mintz.

“Even with good co-mingled sponsors that are well-established, the co-investor terms are getting more aggressive,” Simpson said. “Folks are starting to push a little bit more on the margins to get better terms for the co-investor.”

Featured image by Nicolaus Czarnecki/Getty Images

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