Originally Published in The Legal Special 2013 - A Private Equity International Supplement on April 1, 2013.

Interest in co-investment rights has spiked recently as institutional and other fund investors have sought to enhance their capital deployment, lower expenses and corner differentiation opportunities. These goals can be accomplished with a successful co-investment programme whereby investors garner co-investment rights, build analytical capabilities and streamline procedures for quick action.

This article examines common considerations and complications of co-investments. For simplicity, it hypothesises a middle-market leveraged buyout fund manager (Manager) going to market to raise an institutional fund (Fund 2) after successfully deploying the capital of their prior fund (Fund 1).

Who should get co-investment rights, and when?

Our Manager should assume there will be pressure to grant co-investment rights, and should first develop a strategy as to whether, how, and when to grant them to any subscribers for Fund 2. Fundraising takes a long time and usually has several unexpected developments, and our Manager would be properly guided by the following principles:

• negotiating definitive co-investment rights can be time-consuming and distracting to the main focus of raising capital
• granting definitive rights could become onerous in fundraising by creating a ‘haves’ and ‘have-nots’ investor base, jeopardising investor relations in the future
• granting all investors co-investment rights is neither strategic nor sane, as the process of implementing the rights would be weighty and leave any need for co-investment dollars impossible to fill
• identifying a highly strategic recipient of co-investment rights who can exercise the rights with alacrity and substantiate the ability to fund them (with an equity commitment letter, for example) may be sufficiently differentiated to warrant definitive rights

The above considerations generally mean the final Fund 2 limited partnership agreement (LPA) and side letters will acknowledge certain investors’ interests in co-investing, but leave the Manager the flexibility to deal with co-investment opportunities in the manner most conducive to adding value to Fund 2’s portfolio companies.

Co-investment rights are not for everybody. The Manager, the co-investors, Fund 2 and the recipient portfolio company should all derive specific, tangible benefits from co-investments. The obvious benefit: co-investment dollars can complete a financing round. Less obvious: the Manager or the portfolio company should be able to reap a strategic benefit from the co-investors. The Manager wants to woo support for its next fund; but more so, the Manager wants to add value to Fund 2’s portfolio company. A co-investor may add such value by, for example, filling an ‘outside’ director role on the portfolio company’s governing board, introducing strategic relationships to the company, providing discreet IT or other operating systems advice, or offering industry expertise.

Equally important is the ability of co-investors to be able to independently evaluate an investment and move fast toward consummating it. Requiring a high ability to independently assess a co-investment opportunity is a risk mitigation strategy for the Manager. Fund 2’s LPA or side letter should provide that, subject to executing the same kind of NDA as Fund 2, co-investors will be entitled to the same due diligence materials as the Manager receives, will independently evaluate the investment opportunity, and will not rely on any representations from the Manager or the fact that Fund 2 invests as an indication that it is an appropriate stand-alone investment for the co-investor.

Structuring Co-Investments

Co-investments can be structured as direct or indirect investments. With direct investments, co-investors own directly (or indirectly through a vehicle they control) a stake in the portfolio company. In this case, the investor is a party to the portfolio company shareholders’ or operating agreement (just like Fund 2). The investor decides how it will vote its interests in the portfolio company, whether to fund any pre-emptive right, or whether to exercise tag-along or participation rights and any other action required in connection with rights and obligations of investors in the portfolio company. Direct co-investment is generally only done by investors who have the infrastructure to analyse and manage individual portfolio positions.

Co-investors who invest indirectly alongside the fund are usually aggregated in a single special-purpose co-investment vehicle (SPV), formed as a limited liability company or limited partnership. LLCs are not always conducive to use by foreign investors and may have different tax treatment; whereas limited partnerships are generally recognised by the home jurisdiction of the inbound foreign investor. As an SPV is essentially a fund with a single portfolio investment, the limited partnership form also has the added comfort of looking and feeling very much like Fund 2’s LPA. Since the SPV is a pooled investment vehicle with a strategy similar to Fund 2’s, Fund 2’s LPA must allow the Manager to manage the SPV simultaneously.

Each structure accommodates the use of blocker entities if there is a group of investors that needs to avoid flow-through tax treatment. In the SPV model, the blocker entity can block both co-investors and Fund 2 investors through the use of a single Alternative Investment Vehicle (AIV) (assuming the Fund 2 document allows for AIVs). In the direct investment, the blocker can be inserted between some of the co-investors and not others, but the expenses of the blocker entity become the responsibility of the blocked smaller subset of investors.  By contrast, AIVs and their blockers are usually fund expenses. The illustration below depicts the use of blockers in each structure.

When designing an SPV, a host of fundlike questions should be considered:

• what are the economics to the Manager? (discussed below)
• should there be a pass-through of certain rights to the investor group?
  • rollover on exit
  • preemptive rights
    • what if there is a ‘pay to play’ provision and not all investors want to play?
    • what about priority rights to follow-on rounds?
  • vote on certain fundamental actions (e.g., mergers, financing, valuation)
• should co-investors have a no-fault right to remove the Manager?
• should the Manager be able to take distributions from the SPV to satisfy a default by the investor on its commitment at the fund?
• should a sub-group of co-investors speak for the entire group? On what issues?
  • valuations?
  • votes or other actions taken which are not also being taken in the same way by the fund?
  • board representation at the portfolio company level?

Finally, expenses must be addressed head-on. Fund 2’s LPA should expressly deal with what expenses need to be allocated between Fund 2 and the SPV, and the SPV should expressly provide for how ongoing expenses will be funded.

• Obvious: transaction costs should be split based on the aggregate dollars invested in the portfolio company by both Fund 2 and the SPV. If the portfolio company bears the transaction costs, both Fund 2 and the SPV should bear their share pro rata with all other portfolio company shareholders.
• Less Obvious: the SPV’s formation costs are sometimes considered part of the transaction costs on the theory that the deal would not be done without the co-investment funds. This is dilutive to Fund 2’s investors who are not also co-investors. Ongoing expenses of maintaining the SPV should be the SPV’s expense, e.g. tax returns, third-party (back-office) administration (fund investors (and the Manager) do not want the Manager burdened with the SPV’s operating expenses). But where is the cash to pay such expenses, since no capital calls are to be made in the SPV? These expenses must be funded by the co-investors or by a loan from the Manager (with interest), all repaid out of liquidity proceeds. Such interest should not be subject to a management fee offset under Fund 2’s LPA. Careful planning is needed here.
• Conflicting: some co-investors will insist that an SPV be audited; others will not want to spend the money. So two SPVs may be required.

Economics of Co-Investment Rights

No matter how the co-investment is structured, there’s always a question about whether the Manager should be entitled to a management fee or carry on amounts co-invested. Investors often seek co-investment opportunities to reduce the overall expense ratio of their investments. The majority of co-investment rights are without additional economics – either management fee or carried interest – to the Manager on the theory that the Manager is already being compensated for managing the portfolio company into which the co-investment dollars are flowing. Where there are no co-invest economics, the Manager has fewer concerns about allowing co-investors to invest directly. However, to maintain control and prevent the co-investor group taking a position relative to the portfolio company that is not in the fund’s best interests, the Manager usually prefers the SPV approach.

The SPV structure also facilitates compensation to the Manager from the outset or in the future. There are generally two configurations where the Manager does earn additional economics: a reduced management fee and carry on co-invested monies (generally not more than 50 percent of Fund 2’s management fee and carry), or no management fee and a reduced carry (again, usually not more than 50 percent of Fund 2’s carry). An SPV entity would structure these payments in the same manner as Fund 2. The carry, if any, in the SPV is usually not offset with losses incurred on prior liquidated Fund 2 investments and is payable upon disposition of the investment regardless of whether all capital has yet been returned in Fund 2. But it is subject to clawback by the SPV in the same fashion as Fund 2’s carry distributions.

Co-investments are intended to co-exist with Fund 2’s investment and generally the Fund 2’s LPA will require that co-investments be invested at the same time and on the same terms and conditions as Fund 2, and be exited at the same time. But that may not always be achievable – and sometimes may not be in the best interest of Fund 2, the co-investors or the portfolio company. Consider the potential scenario:

• Fund 2’s portfolio company is to be sold to a roll-up platform where there is an opportunity to reinvest proceeds in the acquiring platform vehicle at a time when Fund 2 should be exiting its investments. Can the rollover opportunity be taken in full by the co-investors? If so, and the Manager is to manage the now standalone funds going forward, shouldn’t the Manager be entitled to economics? Readers should be thinking to themselves. “Having such opportunities is one of the reasons they co-invest, so ‘no’ should obviously be the answer.” But consider:
  • the Manager’s view is probably not the same and if economics to the Manager are not pre-ordained, but have to be negotiated at the time, is the Manager as inclined to pursue that opportunity as the co-investor wants?
  • a co-investment vehicle could be amended to add such economics, but a fee or carry is generally not imposable without the consent of each payor, so the Manager may need 100 percent participation to gain those economics – leaving one co-investor able to block the will of the majority – or be required to reconstitute the participating group in another vehicle, losing efficiencies and subjecting the whole construct to often distracting and expensive renegotiation.

Avoiding Conflicts of Interest

In any co-investment arrangement there is ample opportunity for conflicts of interest to arise. Circumstances will dictate how to manage a potential conflict of interest.

Generally, our Manager is required to offer to Fund 2 any investment opportunity ‘suitable’ for it. Thus, there is immediate and palpable pressure on the decision whether a co-investment opportunity even arises. Policies and procedures defining criteria for determining suitability are essential. Sometimes, suitability is easy to determine (i.e., if the commitments remaining to be deployed by Fund 2 are limited), other times not (i.e. when the suitability factors are based on strategic fit, sector or geographic exposure or similar intangibles). Reviewing that policy should be integral to any investor’s due diligence.

If the Manager is a registered investment adviser, then the Manager’s Code of Ethics and Compliance Manual should contain the Manager’s allocation methodologies. If not yet registered, the Manager‘s allocation methodology should be in writing and available to investors.

If an SPV provides for a reduced carry on co-invested amounts, investors should be cautious about the potential misalignment of interest that creates. Since the SPV’s carry is dependent only on the one portfolio investment, the Manager’s incentives are different with respect to that investment than with Fund 2’s portfolio as a whole. Charging the carry is thus an appropriate topic for clearance with the fund’s limited partner advisory committee (LPAC). But even with LPAC approval, the Manager is subject to criticism based on fiduciary principles if, later, it receives carry from the co-investment when the investors in Fund 2 incurred offsetting losses.

The Co-investment Process

When a co-investment opportunity is identified, there is generally a need to move fast. The ‘alacrity factor’ should be a consideration in assessing to whom a Manager should provide co-investment rights: how fast can the co-investor evaluate an opportunity, make a decision, deal with the final adjustments in the deal, and have availability to sign documents, close and fund? By the time the Manager has enough definition on the terms and conditions of the investment, it is generally fairly close to closing. The ‘alacrity factor’ is generally low and the Manager may want to close with just the fund and syndicate out participation rights to the co-investors, in which case the deal documents must allow for this. To accommodate the ‘alacrity factor’:

• NDAs should allow for providing diligence information to co-investors
• managers should have a process to allow co-investors to interview the CEO and others as needed
• deal documents should be presented on a take-it-or-leave-it basis – comments should not be allowed by the co-investors (though this should not stop co-investors from asking questions and expressing their concerns – and they should be invited to do so).

Other Important Issues

Many other issues – too numerous to discuss here – should be considered in structuring co-investments. For instance:

• does the SPV need to qualify as a ‘venture capital operating company’?
• should the SPV be reusable for follow on rounds in the same portfolio company? What if the rounds are not funded on a pro rata basis by the co-investors?
• if the fund and SPV together have control of the portfolio company, how is any “control liability” to be shared?
• how is the SPV to be treated on the Manager’s Form ADV and Form PF filings? Does the SPV trigger any need to revise the Manager’s Compliance  Manual or Code of Ethics?
• if it is a vehicle used to warehouse an investment until the applicable fund has its initial closing, should the SPV be able to “sell” a portion of its investment to Fund 2 or to Fund 3? What price should the fund pay?
• should the SPV be subject to LPAC scrutiny?

Conclusion

Structuring co-investments requires careful planning at all stages of a fund life cycle – design and formation, fundraising, deal execution, monitoring, and harvesting. If a Manager does not do this, opportunities to support investments and build relationships through a co-investment program will be limited.