By: Henry Riffe and Jeffrey Hart
Co-investment opportunities continue to grow in popularity with institutional investors and fund sponsors, and co-investments continue to play an important role in alternative asset investments. A “co-investment” generally is a portfolio company investment made by an institutional investor, in its discretion, alongside a sponsor’s “blind pool” investment fund. This article describes some of the advantages that co-investments offer to both investors and sponsors, in addition to several of the terms commonly negotiated in such transactions.
Some Important Advantages of Co-Investments
a) Advantages to Institutional Investors
Co-investments offer several advantages to institutional investors in comparison to traditional fund investments. Most notably, sponsors often charge reduced management fees and carried interest, if any, on co-investments. As public pensions and others face increased pressure from stakeholder groups to reduce fees paid to private equity firms, the ability to “average fees down” with co-investments is appealing.
Co-investments also allow institutional investors to place additional capital with a successful manager, which may be attractive to investors with small allocations to the manager’s traditional fund. Further, co-investments provide investors with greater control over their deployment of capital, especially with respect to timing and amount.
Importantly, institutional investors have the ability to conduct their own due diligence and underwriting in connection with a co-investment opportunity, which may enable the investors to better manage the risk profile and asset allocation of their portfolios. Many institutional investors report better returns on their co-investments compared to their traditional fund investments.
b) Advantages to Sponsors
Sponsors often are happy to provide co-investment opportunities to investors, so long as the sponsors retain flexibility and the investors act quickly when opportunities arise. Given robust investor demand, many sponsors find that offering potential co-investments is critical to raising capital for their traditional funds.
Co-investments also allow managers to do larger and more deals. A sponsor may not get access to a particular opportunity unless it can deploy a certain amount of capital. If the sponsor is unable or unwilling to make the entire investment out of its traditional fund, because of investment limitations or diversity concerns, a supplemental co-investment structure may allow the sponsor to participate in full. By allocating a portion of each investment opportunity to co-investments, a sponsor also may be able to place more investments in its traditional fund and achieve greater diversification.
When a sponsor elects to make an investment from its traditional fund, the incremental increase in time and cost associated with managing an additional co-investment vehicle may be immaterial. Accordingly, any opportunity to earn extra management fees or carried interest is welcomed. Further, since a sponsor’s carried interest for its traditional fund is often linked, more or less, to the performance of the fund’s entire portfolio, a sponsor can earn a carried interest in a co-investment vehicle that is unaffected by other investment losses.
The Right to Co-Invest
Institutional investors often attempt to negotiate, in advance, the right to co-invest with the traditional funds in which they will participate. Investors may request that a sponsor allocate opportunities to them prior to other investors, fund management or third parties. Such an attempt may be successful with a new fund sponsor or a very large investment, and a fund manager often will agree not to take co-investment opportunities for its own account without approval.
More common than receiving priority over third parties or even other investors, however, is for an investor to receive a simple non-binding side letter acknowledgement of its interest in co-investments. Sponsors prefer this approach because it provides flexibility to allocate co-investments in accordance with the demands of the situation (e.g., to the individuals who sourced the deal, strategic co-investors and key advisors).
Investors also may wish to negotiate co-investment economic terms in advance. While investors may find it desirable to hard-wire co-investment fees and carried interest in a fund partnership agreement or side letter, such provisions may backfire and result in fewer co-investment opportunities if the sponsor is unhappy with the results.
Commonly Negotiated Co-Investment Terms
Co-investments may be structured in a variety of ways. In some instances, a co-investment may be made directly in a target company, often without any management fees or carried interest payable by the co-investor. Although this simple structure can produce better economic returns and increase control, many institutional investors lack personnel with the requisite time, experience and expertise to underwrite and monitor a direct portfolio company investment.
More typically, a co-investment is made through a vehicle created by the sponsor and organized as a limited liability company or limited partnership, the documents of which often look very similar to a traditional fund partnership agreement. The co-investment vehicle may be an “overflow” entity that will co-invest automatically with the traditional fund in every available opportunity, or the vehicle may be deal specific. The remainder of this section assumes that a deal specific co-investment is made through some type of entity.
a) Allocation of Fees and Expenses
As mentioned above, sponsors often charge reduced (or no) management fees and carried interest with respect to co-investments. Regardless of the management fees charged at the co-investment level, the allocation of “special fee” benefits between the co-investment vehicle and the sponsors’ other managed funds can be complex.
Consider, for example, a case in which there is no management fee in respect of a co-investment vehicle, and thus no fee to offset by special fees. In this situation, the co-investment vehicle’s pro rata portion of any special fees (based on the relative amounts invested by the vehicle and the sponsor’s traditional funds) may be (a) retained by the sponsor in their entirety, (b) applied as an additional offset to the management fees charged at the traditional fund level, or (c) contributed to the co-investment vehicle for the benefit of its investors. Co-investors often negotiate for the second or third option.
Investment expenses must be allocated between the co-investment vehicle and the traditional fund as well. Typically, expenses that relate clearly to the co-investment vehicle (e.g., organizational expenses) are borne by that entity, and expenses incurred for the benefit of both entities (e.g., due diligence expenses) are shared in accordance with their respective investment amounts. Broken deal expenses are more nuanced because the co-investment vehicle often is unfunded if the transaction does not close. In practice, however, such expenses are often borne by the sponsor’s traditional fund.
After closing, sponsors may use a number of strategies to pay a co-investment vehicle’s future operating expenses (e.g., accounting and tax return preparation expenses and indemnification expenses). If co-investors will invest 100% of their capital at the time of the investment, a sponsor may bear operating expenses subject to reimbursement if and when the investment generates cash flow. Alternatively, co-investors may agree to pay operating expenses outside their invested capital. In these situations, co-investors will want to negotiate an annual or aggregate cap on the amounts to be paid or, at a minimum, make their investment through a special purpose entity that provides limited liability. Finally, co-investors may have a capital commitment similar to a limited partner’s commitment in a traditional fund, with the unfunded portion to be drawn and used at the sponsor’s discretion.
b) Exercise of Target Investment Rights
Private equity and venture capital investments often include a bundle of participation rights with respect to the portfolio company, such as preemptive rights, rights of first refusal, tag-along rights and registration rights. A sponsor makes all investment related decisions and elections on behalf of a traditional fund, but co-investors may desire more control and influence over such matters.
In many instances, the governing documents of a traditional fund and a related co-investment vehicle provide that their respective investments must be made and managed similarly, including with respect to pricing and liquidity. In most respects, the interests of the investors in each entity are aligned, but the possibility of follow-on investments can lead to conflicts.
A sponsor may want to allocate a co-investment vehicle’s future investment rights to the sponsor’s traditional funds. One reason is because a sponsor typically is unable to cause a co-investment vehicle to make follow-on investments, since the investors do not have substantial (if any) unfunded commitments. Accordingly, the sponsor may wish to retain and assign future investment rights to preserve their benefit. Further, the sponsor has a financial incentive to divert future investments to its traditional funds because it often can earn greater fees and carried interest distributions.
Co-investors may want, however, an opportunity to increase their exposure to a successful investment. As a result, co-investors may require the sponsor to offer follow-on investments (whether pursuant to an exercise of preemptive rights, first refusal rights or otherwise) to the co-investors, which may be made within the existing co-investment vehicle or through a new entity. Alternatively, co-investors may want the sponsor to assign those rights to the co-investors directly, which would allow them to exercise the rights at their discretion.
Similarly, co-investors may want or need liquidity at different times. Accordingly, they may require the sponsor to structure a co-investment vehicle so they can exercise indirectly any tag-along rights or registration rights at the portfolio company level.
c) Cross Defaults
As mentioned above, traditional funds and co-investment vehicles normally are managed in tandem with respect to their shared investments. Co-investors often want any material governance changes and other similar events at the traditional fund to have a corresponding effect at the co-investment level.
For example, a traditional fund’s limited partnership agreement may permit the removal of the general partner (with or without cause, and with a potential reduction in its carried interest) and a termination of the fund by the investors, in addition to a prohibition on general partner interest transfers and changes of control. Co-investors likely will want similar rights and protections at the co-investment level.
The simplest approach is to have “cross default” provisions whereby material changes at the traditional fund are automatically mirrored at the co-investment vehicle. In many instances, however, this may be inappropriate. For example, a sponsor may commit bad acts with respect to the shared investment that would be material to the co-investment vehicle but not the traditional fund. Thus, co-investors may want an independent right to remove the sponsor or shut down their vehicle.
Co-investments can serve as an effective and cost efficient supplement to the traditional fund investments of institutional investors. And co-investments can be used by sponsors to enhance their capital raises and facilitate the making of larger investments. However, co-investments also pose material risks and conflicts, which should not be addressed simply by replicating the terms of the corresponding traditional fund. Where desirable and applicable, co-investors should focus on terms and issues that provide them with greater flexibility and control over their co-investment dollars.
Henry Riffe practices corporate and commercial law at Robinson Bradshaw with an emphasis on private equity and venture capital transactions and mergers and acquisitions.
Jeffrey Hart is the founder of Triangle Funds. At Robinson Bradshaw, his primary areas of practice include private fund formation, private investment transactions, joint ventures and other business transactions.