Co-investments play an important role in alternative asset investments. A “co-investment” generally is a portfolio company investment made by an institutional investor, at its discretion, alongside a sponsor’s “blind pool” investment fund. This post describes some benefits and risks of co-investments, both to investors and sponsors, and some of the commonly negotiated terms.
Co-investments offer several advantages to institutional investors compared to traditional fund investments. 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 let institutional investors place additional capital with a successful manager, which may be attractive to investors with small allocations to the manager’s traditional fund. Co-investments also afford investors greater control over their deployment of capital, especially regarding timing and amount. Institutional investors can conduct their own due diligence and underwriting in connection with a co-investment opportunity, which may enable them to better manage the risk profiles and asset allocations of their portfolios.
Sponsors often are happy to provide co-investment opportunities to investors, so long as the sponsors retain flexibility and control and investors act quickly when opportunities arise. Co-investments also allow sponsors to do more and larger deals. A sponsor may not access 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 let the sponsor participate in full. By setting aside a portion of each investment opportunity for co-investments, a sponsor may also place more investments in its traditional fund and achieve greater diversification. Co-investments provide sponsors with a potential opportunity to earn extra management fees or carried interest without a material increase in work. 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 unaffected by other investment losses.
Institutional investors often try to negotiate in advance the right to co-invest with the traditional funds in which they will participate. Investors may ask a sponsor to allocate opportunities to them before other investors, fund management or third parties. This attempt may succeed with a new fund sponsor or a large investment, and a fund manager often will agree not to take co-investment opportunities for their 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 acknowledging 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 (such as 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 want 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.
Co-investments may be structured in several ways. A co-investment may be made directly in a target company, often with no management fees or carried interest payable by the co-investor. Although this simple structure can increase control and produce better economic returns, many institutional investors lack staff with the requisite time, experience and knowledge to underwrite and track a direct portfolio company investment. More typically, a co-investment is made through a special purpose vehicle (an SPV) created by the sponsor and organized as a limited liability company or limited partnership, the documents of which often look similar to a traditional fund partnership agreement.
An SPV for every co-investment transaction can be burdensome in time-sensitive situations, so some fund managers instead create an “overflow” co-investment vehicle with permanently modified economics. Each investor participates in both the main fund and the co-investment fund, and a dedicated percentage of its capital commitment is assigned to each entity. When co-investment opportunities arise, they are funneled into the co-investment fund to benefit all participants. For investors, this strategy gives all investors identical co-investment rights (that is, no special deals) and “cross-collateralizes” the sponsor’s carry (if any) with respect to all co-investment opportunities. For the manager, this hard-wired approach streamlines the co-investment process, responds to investors’ requests for more deals and provides increased capacity to respond promptly to investment opportunities as they arise.
Sponsors often charge reduced (or no) management fees and carried interest in 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 a case in which there is no management fee for 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 another offset to the management fees charged at the traditional fund level or (c) contributed to the co-investment vehicle to help 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 (such as organizational expenses) are borne by that entity, and expenses incurred to benefit both entities (such as due diligence expenses) are shared in accordance with their respective investment amounts. Broken deal expenses are more nuanced because the co-investment vehicle is often unfunded if the transaction does not close. However, such expenses are often borne by the sponsor’s traditional fund.
After closing, sponsors may use several strategies to pay a co-investment vehicle’s future operating expenses (such as accounting and tax return preparation expenses and indemnification expenses). If co-investors invest 100% of their capital at the time of the investment, a sponsor may bear operating expenses subject to reimbursement if the investment generates cash flow. Alternatively, co-investors may pay operating expenses outside their invested capital. In that event, co-investors typically seek an annual or aggregate cap on the amounts to be paid or, at a minimum, make their investment through an SPV 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.
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. Often, the governing documents of a traditional fund and a related co-investment vehicle state that their respective investments must be made and managed similarly, including regarding 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 assign a co-investment vehicle’s future investment rights to the sponsor’s traditional funds. One reason is that a sponsor typically cannot cause a co-investment vehicle to make follow-on investments since the investors do not have substantial (if any) unfunded commitments. The sponsor may wish to keep 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, however, may want an opportunity to increase their exposure to a successful investment. Accordingly, they may require the sponsor to offer follow-on investments to them (whether under an exercise of preemptive rights, first refusal rights or otherwise), which investments may be made within the existing co-investment vehicle or through a new entity. In the alternative, co-investors may want the sponsor to assign those rights to the co-investors directly, which would permit them to exercise the rights at their discretion. Similarly, co-investors may want or need liquidity at different times. They may require the sponsor to structure a co-investment vehicle so they can indirectly exercise any tag-along or registration rights at the portfolio company level.
Traditional funds and co-investment vehicles are normally managed in tandem with respect to their shared investments. Co-investors often want any material governance changes and 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. Often, 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 the vehicle in which they participate.
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 more and larger transactions. However, co-investments can generate complexity, conflicts and risks, so they should be structured carefully and deliberately.
