Co-Investing With Searchers: Structures That Align Incentives
When I co-invest with a searcher, the deal structure matters as much as the underlying business. Here is what I have learned about getting it right.
Co-investing alongside a searcher on a specific acquisition is one of the most attractive ways for me to deploy capital. The searcher has done the diligence, the deal is real and identified, and my capital comes in alongside an operator who has a personal stake in the outcome. But the deal structure matters as much as the underlying business, and getting it wrong in the documents creates problems that surface long after close.
The first principle: alignment of operating incentives
The searcher is going to operate the business. The co-investor is not. The structure has to make sure the searcher is rewarded for outcomes that benefit all the equity holders, not just outcomes that look good on the surface.
The standard search fund vesting structure usually accomplishes this. The searcher's equity vests over five to seven years and is tied to specific performance milestones. A co-invest structure that does not include similar vesting is usually too generous to the searcher relative to the LPs.
Preferred return: the conversation worth having
Most search funds have a hurdle rate above which the searcher participates in the upside. Below the hurdle, the LPs get their capital back plus a defined return before the searcher's carry kicks in.
I push for a preferred return on co-invest deals as well, even when the standard model does not include one. The preferred return is not a punishment of the searcher. It is a recognition that the LP capital took on financial risk and deserves a baseline return before the operating equity participates in the upside.
A searcher who pushes back hard on a preferred return is signaling something about how they think about the relationship.
Drag-along and tag-along provisions
Co-invest deals usually have a defined exit window. The LP wants liquidity by year five to seven. The drag-along provision lets a majority of LPs force a sale of the business at that point. The tag-along provision protects minority LPs from being left behind in a sale that excludes them.
Both should be in the documents. A co-invest opportunity that does not include them is one I am less likely to participate in, regardless of how attractive the underlying business looks.
Information rights
Beyond the financial structure, the LP needs information rights that allow real oversight without creating operating overhead for the searcher. Quarterly financial statements, annual operating plans, board minutes (or board observer rights for larger LPs), and notice of material events.
The right level depends on the LP's check size and the searcher's preference. The wrong level (either too restrictive or too burdensome) creates friction that compounds.
What I am ultimately backing
A co-invest deal is a bet on a specific operator running a specific business. The deal structure is the framework that makes the bet survivable if the business underperforms or the operator's plans change.
The operator and the business are the upside. The structure is the downside protection. Both deserve attention.
Written by Ramy Stephanos, SFAdvisor - Capital.