Fund investing vs co-investing vs direct investing
Most investors start by investing through a fund, paying the manager to choose and run the investments. With experience they may co-invest alongside the fund in particular deals at lower fees. The largest and most skilled invest directly, keeping full control but doing all the work themselves.
Before this: What makes an investment alternative: features and categories
On the exam
- Compare direct investment, co-investment, and fund investment methods for alternative investments
Compare direct investment, co-investment and fund investment. Expect to match an investor to a method, to give an advantage or disadvantage of each, and to say why a manager offers a co-investment.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
How can an investor get into alternatives?
Alternatives are long-term, illiquid and hard to evaluate, so investors depend on managers for many years. How much of that dependence you accept is a choice. There are three routes, and institutions usually move up them as they gain experience.
- Fund investing Memorize indirect: the manager selects and runs the deals
- Who limited resources or experience
- Trade-off highest fees, no control over deals, easy diversification
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- Co-investing Memorize in the fund and directly in some of its deals
- Who investors with some fund experience
- Trade-off lower fees and more control, but more skill and oversight cost
-
- Direct investing Memorize no intermediary
- Who the largest, most sophisticated investors
- Trade-off full control and no external fees, but most expertise and resources
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What is fund investing?
In fund investing the investor contributes capital to a fund. The fund, not the investor, finds, selects, makes and monitors the investments. It is an indirect route, and it exists for every major alternative type: hedge funds, private capital, real estate, infrastructure and natural resources.
The investor’s only decision is to invest in the fund or not. In return for fully outsourcing control, the investor pays the highest fees: a management fee plus a performance fee. Funds also differ from ordinary equity or bond funds. Money is committed before any investments are chosen, it stays locked for years, fees are higher and more complex, and positions and returns are reported less often.
An important terms document, the term sheet, lists the fund size, the general partner’s own commitment, the fund term, fees, hurdle and side letter rules. The next two lessons cover those terms.
What is co-investing?
In co-investing the investor holds an interest in the fund and has co-investment rights : the right to put money directly into the same deal. The investor invests alongside the fund, not instead of it.
Co-investors pay a lower fee on the co-invested amount (often reduced management fee and no performance fee), gain more control over that deal, and learn from the fund’s process on the way to direct investing. The cost is more skill and oversight work. The weighing is greater control and lower fees against higher oversight costs.
Why would a manager share a good deal? Three reasons:
- To close a deal faster when the fund’s cash and expected inflows are not enough.
- To widen the set of deals it can pursue.
- To improve the diversification of the fund’s existing portfolio.
Our scenario: a USD 2 billion fund may put no more than 15% (USD 300 million) into any one company. It has agreed to buy a regional cold-storage operator for USD 420 million of equity. Rather than lose the deal or share it with a rival firm, the GP invites its limited partners (LPs) to supply the missing USD 120 million directly, at a 0.5% fee and no carry. The fund stays inside its limit, and the LPs who join get more of a deal they like at a fraction of the usual cost.
What is direct investing?
In direct investing the investor buys the asset itself with no intermediary: a stake in a private company, a building, a share of a project. The investor keeps full flexibility over choice, financing and timing, pays no external manager fees, and carries all the cost of the skills, due diligence and oversight.
Direct investing is common in private capital and real estate. Some very large pensions and sovereign wealth funds also invest directly in infrastructure and natural resources, and compete with fund managers for the best deals.
Due diligence follows the method. A fund investor examines the manager. A co-investor examines the manager and the deal. A direct investor examines every asset.
Exam tip Put the answer on the ladder. Limited experience: fund. Fund experience, wants cheaper and more say on one deal: co-invest. Large with in-house teams: direct.
Go deeper Fund of funds is not co-investing
A fund of funds pools investor money and invests it in several other funds. It adds a second layer of diversification and a second layer of fees. Co-investing is something else: a direct stake in one deal alongside a single fund. Hedge funds is where the fund of funds returns.
Go deeper The adverse selection risk in co-investments
A manager chooses which deals to offer. A co-investor must ask whether it is being offered the deals the manager least wants to hold in full. Doing its own due diligence on each deal is the answer, and it is part of the “higher oversight cost”.
Memorize this
MemorizeThe three methods side by side
| Fund | Co-invest | Direct | |
|---|---|---|---|
| How | Commit to a fund; manager picks deals | Fund plus direct stake in some deals | Buy assets yourself |
| Fees | Highest (management + performance) | Lower (reduced fee, often no carry) | No external fees; high internal costs |
| Control | None over deals | More, on co-invested deals | Full |
| Skill needed | Least | Moderate | Most |
| Diversification | High | Less on co-invested part | Depends on size |
| Typical investor | Smaller, newer, limited experience | Experienced fund investors | Large pensions, sovereign funds |
Memory hook A ladder: step up a rung and you take on more of the work, keep more of the money, and control more of the choices.
Know it cold Fund: easy and costly. Co-invest: cheaper and needs skill. Direct: no external fees and needs the most skill.
MemorizeWhy a manager offers co-investment
Memory hook Speed, scope, spread: close faster, reach further, diversify the pool.
Know it cold To close a deal when the fund lacks the cash or room for it (speed), to widen the set of deals it can do (scope), and to improve diversification of the fund pool (spread).
- Fund investing Memorize indirect: the manager selects and runs the deals
- Who limited resources or experience
- Trade-off highest fees, no control over deals, easy diversification
-
- Co-investing Memorize in the fund and directly in some of its deals
- Who investors with some fund experience
- Trade-off lower fees and more control, but more skill and oversight cost
-
- Direct investing Memorize no intermediary
- Who the largest, most sophisticated investors
- Trade-off full control and no external fees, but most expertise and resources
-
How it is asked
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Match investor to method
An investor with limited experience and a small team would most appropriately use...
Fund investing. Traps: co-investing needs fund experience; direct investing is for the largest investors.
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Co-investing versus fund only
Compared with investing only through the fund, co-investing most likely gives...
Lower fees on the co-invested amount and more control. Trap: higher fees.
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Why offer a co-investment
Which is most likely a reason a GP offers a co-investment?
To complete a deal larger than the fund can hold (concentration limit or cash). Not to raise the fund fee.
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Cost of the same deal two ways
Fund fee and carry versus a reduced co-investment fee on the same stake: what is the saving?
Cost of the fund route (management fee + carry) minus the co-invest fee. Trap: forgetting the co-invest fee.
Exam traps
- Saying co-investors pay higher fees than fund investors. Co-investments usually carry a reduced fee and often no performance fee.
- Saying direct investing needs the least expertise. It needs the most, and the most resources.
- Confusing co-investing with a fund of funds. Co-investing is a direct stake alongside one fund; a fund of funds is a fund that invests in other funds.
- Forgetting that co-investors still invest in the fund. Co-investing adds a direct stake; it does not replace the fund commitment.
Checkpoint
4 exam-style questions. About 90 seconds each.
1An investor with limited alternative investment experience and a small team would most appropriately use:
2Compared with investing only through the fund, co-investing most likely gives the investor:
3Which is most likely a reason a general partner offers a co-investment?
4A pension plan holds USD 80 million of a deal for one year through a fund that charges a 1.5% management fee on that amount and 20% carry on the USD 20 million gain (hurdle ignored). The plan could hold the same USD 80 million as a co-investment at a 0.5% fee and no carry. The saving from co-investing, in USD millions, is closest to:
Key takeaways
- Fund investing: easy, diversified, expensive, no deal-level control.
- Co-investing: alongside the fund, cheaper, more control, needs more skill and oversight.
- Direct investing: full control, no external fees, the most expertise and resources.
- Managers offer co-investments to close big deals faster, widen opportunities and improve diversification.
All Alternative Investments formulas, every lesson
Practice exam-style questions on Alternative Investment Features, Methods and Structures
Questions about this lesson?
Where this comes back
- Ownership structures: general and limited partners Alternative Investment Features, Methods and Structures
- Hedge Funds Alternative Investments
- Private Capital: Private Equity and Private Debt Alternative Investments
Questions candidates ask
What is the difference between fund investing and co-investing?
In fund investing the investor commits capital and the fund manager selects and runs the investments. In co-investing the investor also holds the right to invest directly alongside the fund in particular deals, usually at lower fees and with more control.
Why do private equity funds offer co-investments?
To close a deal larger than the fund's single-investment limit or available cash, to widen the set of deals it can pursue, and to improve the diversification of the fund's portfolio. It also strengthens relationships with investors.
Who invests directly in alternative assets?
The largest, most sophisticated investors, such as big pension funds and sovereign wealth funds. They have the skills and resources to find, finance and oversee individual assets without a fund manager, and so pay no external manager fees.
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