Co-investment equity has become a ready source of capital in recent years for managers looking to make big-ticket purchases as fund investors clamor for greater direct exposures and better returns.

Yet, the strongest case managers can make to prospective co-investors – aside from buying more of an asset of choice – is economic, with reduced management fees and carried interest implications.

“It definitely starts with the lower fees,” says Jennifer Wenzel, head of the Texas Teachers Retirement System’s Real Estate/Real Assets Principal Investment program. “That’s obviously a source of alpha driving everyone first of all. There’s a discount [in co-investing].”

Perspectives on fees vary from the largest managers, such as Blackstone and Starwood, which offer no discounts to their fund rates; to well-heeled investors that feel there is a case to be made for paying no co-investments fee. The wisdom there is they do not have to pay for corporate private equity deals so why should they here?

Merrill: lower fees don’t always mean better value

Most managers will discount fees and carry on co-investments by 25-50 percent, PERE understands. The theory is investors get a sweeter deal in exchange for the increased risk of direct exposure and the hardship of drumming up big cash on short notice. Managers, on the other hand, still get compensated for sourcing a deal on behalf of the sidecar and operating the asset in question.

As co-investment evolves, however, some sponsors are using these vehicles as tools to strengthen – or even start – relationships with investors. Jeff Jacobson, global chief executive officer of Chicago-headquartered manager LaSalle Investment Management, says additional co-investment fee breaks are sometimes used to reward major fund investors.

Jacobson, whose firm both sponsors funds and serves as a discretionary investor for a handful of institutions, says some investors that make large, early fundraising commitments can use that clout to negotiate co-invest rights and fees that are “close to zero.”

“Big, first-close fund investors, obviously, have the greatest negotiating power, because they really ensure the fund gets off the ground,” he says. “Instead of discounting fees heavily in the fund, the other way to reward them or give them economic incentives is to say you can co-invest in a certain ratio to your fund investment at very attractive fees.”

Mega investors are not the only ones pre-negotiating co-invest terms. Other, smaller investors are fighting for co-investment rights to be baked into their term sheets – even those that are ill-equipped to take advantage of them. These include dollar-for-dollar guarantees and fees breaks.

Top investors aside, the discount fee rate hangs, primarily, around 50 percent of that of the underlying fund, multiple investors and managers confirm. Some cash-strapped sponsors will dangle steeper discounts to win over new investors, but that is not typical, Christopher Merrill, founder and CEO of Harrison Street Real Estate Capital, another Chicago-based manager, tells PERE.

“Fees are always a topic within any strategy and every manager is different,” Merrill says. “I think there are some managers that do things for lower fees. But as my mother always taught me, you get what you pay for.”

Annette Kroeger, CEO of Allianz Real Estate in North and Central Europe, says even her firm, which has more than €60 billion in assets under management and a history of direct investment, still usually pays about 50 percent fees on co-investments.

When the German insurance company opts for co-investment over direct investment, it is usually because it does not have the local expertise required for the hands-on work. In that sense, Kroeger says she does not mind paying incentive-based fees “because you also have better performance for yourself.”

Still, some large investors would like to see fees for real estate co-investments fall to zero, as they have in corporate private equity equivalent vehicles, for which co-investment has been more popular for much longer. Wenzel of Texas TRS says there is an argument to be made to managers that deal in both spaces, but she does not hold much hope for a change.

“Maybe with some of the global opportunity funds … we can say, ‘We just did a co-invest with you in private equity and it was no fee, no promote.’ But I don’t see a lot of movement there right now, honestly. The only place there could be movement is with the global funds that have a PE side. A lot of our managers don’t have that PE counterpart, so it’s a harder argument.”