This article was published in the Private Equity and Mergers & Acquisitions sections of Law360 on December 8, 2015. © Copyright 2015, Portfolio Media, Inc., publisher of Law360. It is republished here with permission.

Although co-investments are not new, private equity groups (PEGs) are increasingly seeking opportunities to offer others — including their own limited partners (LPs) — the chance to invest in their deals. The trends show that PEGs have been closing deals with more frequent co-investor participation and with significant dollar contributions from such participants. A new study sponsored by Pepper Hamilton LLP in association with Mergermarket, “Joining Forces: The Co-investment Climate in Private Equity,” identifies key data points illustrating some of the latest developments in co-investments:

• 100 percent of funds surveyed offer co-investment opportunities, with 56 percent of general partners (GPs) actively exploring investment opportunities that enable their funds to offer occasions to co-invest and 42 percent offering co-investing on an opportunistic basis.
• 62 percent of funds surveyed stated that, of the last 10 deals closed, between 21 percent and 40 percent of such deals were closed with the participation of co-investors.
• 64 percent of GPs say that co-investors have contributed between 21 percent and 40 percent of the dollar value of equity invested in deals done by their funds.

The importance of these numbers should be self-evident: co-investments are an increasingly important component of capital used by PEGs to fund acquisitions and represent an increasingly significant portion of this capital.

Driving Forces

So, why are PEGs relying more on co-investments? The survey attempted to uncover the reasons behind this trend by asking PEGs what were the biggest drivers today for offering co-investment opportunities. Twenty-six percent of funds cited risk sharing, which is a common rationale for pooling capital — whether through a co-investment mechanism or, frankly, in the creation of private equity funds themselves. The rest of the responses, however, reflect the reasons behind the current growth in co-investment transactions:

• To facilitate the fundraising process/to obtain capital commitments from investors (22 percent)
• Investors’ strategic alignment with PE portfolio companies (16 percent)
• To build relationships/goodwill with (potential) investors (12 percent)
• To gain operating partners (8 percent)
• To establish relationships with other PEGs (8 percent)
• To fund sponsors’ drive to remain competitive through differentiation (8 percent)

Each of these trend drivers capitalizes on relatively new developments in private equity and collectively must be taken into consideration by PEGs going forward. For example, as investors continue their convergence efforts and invest in significantly fewer funds, fundraising concerns have become paramount to PEGs. This dynamic has been driving funds to focus continuously on fundraising, even when not actively raising capital, including by making decisions designed to enhance their ability to facilitate future fundraising (as opposed to prior generations of funds, which focused on fundraising only when it was time to raise additional capital in a new fund). Thus, funds now offer co-investment opportunities directly to facilitate the fundraising process and obtain capital commitments from investors, as well as indirectly to build goodwill and develop relationships with new potential LPs.

Benefits of Co-Investments

While we understand the rationale for providing co-investment options to existing LPs, finding other investors for co-investments presents a chance for the PEG and the other investors to develop a history of investing together. Firms can capitalize on this familiarity by offering these co-investors the opportunity to become an LP in the firm’s next fund. Firms also use co-investment strategies to facilitate differentiation and specialization and to capture high-quality operating partners. Co-investment furthers the competitiveness of the PEG and therefore enhances its future fundraising activities.

For example, a PEG with a particular industry focus might have a key strategic advantage in bringing a co-investor on board — a pharmaceutical company, for instance, that is looking to invest in a pharma-focused fund in order to gain access to drug development insights. Even using co-investment opportunities to establish relationships with other PEGs enhances future fundraising by enabling a fund to leverage the work of its new PEG relationships to find quality, fair-priced deal flow — a difficult task in this market.

Considerations and Challenges

Despite their benefits, co-investments are complex and need to overcome a few regulatory hurdles. Indeed, the survey revealed that 76 percent of respondents cite regulatory scrutiny as one of the biggest challenges to co-investments (with lower returns for sponsors coming in a distant second at 56 percent). And, 30 percent of those surveyed see regulatory scrutiny as the biggest hurdle facing PE co-investments.

Regulation-related concerns about co-investments include simple, but potentially costly, requirements, such as the co-investment vehicle being required to maintain separate books and records, having an annual audit and being subject to U.S. Securities and Exchange Commission examination. But they also include much more complicated fiduciary duty and disclosure-related concerns.

For example, recall that one of the key drivers to offering co-investment opportunities is to help build relationships and/or goodwill with (potential) investors. If a fund manager is close to raising a new fund, the manager may offer a no management fee or no carry co-investment opportunity. Not only will the foregone revenue have a negative economic impact on the PEG, but a regulator could view this as a special inducement to the potential investor to obtain an investment in the new fund.

Similarly, transaction fees and expenses are areas of particular regulatory attention and get complicated with co-investment vehicles. Unlike a regular fund, where transaction fees generally offset management fees and accrue to the benefit of the LPs, a co-investment can be with LPs who have negotiated different terms as to the offset itself, or as to the management fee being offset. These terms need to be examined for conflicts of interest every time a fee or expense is allocated between the fund and the co-investment vehicle, and the allocations and waivers must be explicitly disclosed in all private placement memoranda.

Fortunately, the solution is not to abandon the potential benefits to PEGs of using co-investment opportunities to build relationships and/or goodwill with (potential) investors, but rather to focus on enhanced disclosure during the fundraising process and to develop policies and procedures that reflect industry best practices. The goal is for both the promoter and the funds to engage in co-investments while insulating themselves from liability in an environment of enhanced regulatory scrutiny. In addition, the parties should be able to agree on those allocation issues in the definitive agreements between them.

There are other structuring and documentation complexities as well. If a PEG’s intended purpose in offering co-investment opportunities is to build relationships with potential LPs, one might assume that the negotiated terms of the co-investment relationship will be investor friendly. However, this is not necessarily the case. The deal term most often included in co-investment transactions — as noted by 68 percent of respondents — is tag-along rights, followed by the obligation to fund follow-on investments proportionally (58 percent) and requiring a separate audit of the co-investment vehicle (52 percent), all of which are investor-side rights. However, terms that impact GP economics (such as reducing or eliminating the carry or management fees) were among the lowest on the list of respondents’ concerns. Even terms that impact an investor’s control rights (such as board seats for co-investors) were listed much less prominently than the top three noted above, and less prominently than clear GP-favorable provisions, such as drag-along rights.

Although LPs clearly benefit from receiving these co-investment opportunities, co-investment relationship terms, in general, are not particularly investor- or GP-oriented, but rather reflect a middle position based on giving each party what they need most. For example, it may seem odd that PEGs get drag-along rights in less than a majority of circumstances (46 percent), but there are many things PEGs can do to help them retain effective control of an investment, including, for example, employing sophisticated structuring techniques by using multiple holding companies. This allows a PEG to structure investments so that it controls the portfolio company, even though it may have just a minority piece of the equity. This is important, as not having control of the portfolio company can be dangerous for the PEG.

For one, having so many different parties involved usually means different interests are present. PEGs themselves have three- to five-year investment windows, and generally seek to maximize common equity value, although preserving preferred equity value may instead become an important consideration. Lenders, on the other hand, would look to protect their debt interest before preserving the value of the equity. The founder will have a much longer time horizon than both the PEG and the co-investor(s), and, if still active in running the business and thus a significant participant in management’s incentive equity plan, may have more interest in common equity value than preferred value. Consequently, when critical decisions have to be made, these potentially conflicting interests emerge. Without effective control of the portfolio company, coalitions can be formed and votes can be taken where the outcome is uncertain.

Conclusion

The rise of co-investments has changed the nature of a private equity fund’s relationships with its manager, GP and LPs, as well as the buyout market in general. These deals are benefiting private equity in several ways. The risk-sharing benefits remain the key driver, but the immediate and long-term fundraising benefits are really influencing the trend. Accessing a co-investor’s industry expertise and gaining access to operating partners are key benefits to co-investment.

Nevertheless, private equity firms face challenges to make the most of these opportunities. Regulators have shown increasing interest in private equity and, in particular, co-investments, which is costing the industry both in terms of money and distraction, to say nothing of reputation. In some cases, difficulty in agreeing to transaction fees with co-investors also causes additional distraction and likely, when agreement is reached, worse economics. Even where there is no co-investor threat to GP economics, the customary negotiation with co-investors typically creates deal stress and can delay the closing of transactions. However, in this fundraising environment, particularly where LPs are demonstrating increasing ability and desire to do deals on a direct basis (as opposed to through their investment in the PEG or even through co-investment), PEGs really have no choice but to offer co-investment opportunities not only to maximize their competitiveness but, for some, to ensure their survival.