Second LP Investment Pillar: Alignment of Interests
Coinvest, waterfall, and fees
Last week, we laid out three pillars of LP investing:
I suggest reading about the first pillar, Execution, before continuing if you haven’t read it already.
Also, as a reminder, these three pillars are independent. In other words:
You could find an investment that scores really high on two of them, but performs poorly on the third. For examples, visit last week’s post.
Such an imbalance is fine, as long as you are aware that you’re taking on that additional risk and are being compensated for taking it on
The best investments will have risks that you get comfortable with due to their respective mitigants
Alignment of interests - coinvest, waterfall, and fees
First, a quick introduction on this entire section.
As a general rule, when you invest in anything as an LP you are putting your trust (both practically and legally) into the GP to do the right thing.
That is why the first pillar was execution (track record and counterparty risk) - this is something that’s hard to compensate for, but it’s possible.
For instance, a new GP might not have the track record or experience for the given investment, but you still decide to investment based on what you find the other two pillars.
Alignment of interests are important, both in the case of upside (when things go well) and downside (when the investment goes sour). Hope is not a strategy, as depicted in the picture below.
Let me say that again - when you look at an investment as an LP and are trying to decipher whether there’s a good alignment of interests between you and the GP, be sure to think about both favorable and unfavorable outcomes.
A lot of LPs will only focus on the successful outcome, and that’s because the deck tends to show this and is a sales pitch. “The IRR is great, and therefore,” one could say, “the coinvest, waterfall structure, and fees are irrelevant.”
This, of course, is a big mistake. Every GP needs to make money - that’s why they’re presenting you the deal. It’s equally important, though, to ensure that the majority of a GPs earnings comes from actual success rather than the probability of it.
In the three sections below, we’ll touch on all three parts of alignment of interests and I’ll explain why thinking about both favorable and unfavorable outcomes is important for the overall investment decision.
1) Coinvest
Definition: A coinvest is the amount of equity (usually expressed as a percentage of total equity raise) that the General Partner is putting up as part of the deal.
How it works:
A coinvest is the GP’s vested economic interest in the deal at the outset - the day you close.
Although the GP has other interests (the promote, as we’ll discuss below in the waterfall section) it’s important to have both “upside” and “downside” economic incentives. In other words:
Upside -
The GP is economically incentivized to perform, since the upside of the promote is material sum of money that’ll only be realized upon a sale (in most cases). Notice how, in good times, the coinvest matters very little since the promote is services as a material incentive.
Downside -
One of the challenges in GP/LP alignment is ensuring that the deal stays on track. If a project starts to deviate from its intended path, the returns can diminish significantly. In some cases, LP equity might even become entirely worthless (i.e. you lost your entire LP check). This is a scenario I've witnessed repeatedly.
From an economic perspective (and it's essential to highlight that there are also ethical and legal considerations), the most effective way to keep the General Partner (GP) committed to the deal when their promote has diminished in value is by the GP’s coinvest. Specifically, the GP needs to be aware of the substantial monetary loss they could incur on the initial capital that they put up if the project doesn't succeed.
This is precisely where the concept of 'coinvest' comes into play. The coinvest serves as a crucial incentive for the GP to remain dedicated to the project, rather than diverting their attention to other opportunities. In essence, it's a safeguard to ensure that the project receives the attention and dedication it deserves.
What’s market:
A healthy GP coinvest is 5%-10% of the equity raise. Of course, all else equal, the larger this amount is the better.
Things to be careful about: