As co-investments continue to explode in popularity — both from the perspective of fund sponsors and fund investors — my Boston- and New York-based asset management colleagues Adam Dobson, Jessica Marlin and Nicole Krea and I have taken the opportunity, in this podcast, to introduce some of the basic structures as well as related issues that commonly arise in these deals. We also touch briefly on how the SEC’s proposed private funds rules from earlier this year may shift the co-invest paradigm.
Topics we discussed include:
What are the benefits of co-investments?
- They allow fund investors to deploy more capital with a sponsor they like on a no-fee, no-carry basis, which can reduce the overall fee burden on the capital that the investor has deployed with the sponsor.
- They also can be a way for a fund investor to increase its exposure to a desirable asset class or even a particular asset.
- They offer advantages to fund sponsors as well, such as investor relations benefits, as well as helping raise purely passive capital for a deal above the fund’s targeted hold.
What are the typical co-investment terms?
- A co-investor wants to have comfort that it is buying the same securities, in the same proportions, and at the same price and terms as the lead sponsor. If the sponsor is acquiring additional debt or equity securities of the target, the co-invest vehicle should at a minimum have the right to participate proportionally (and some deals provide for dry powder, so co-investors participate automatically in any follow-ons).
- Likewise, the co-invest vehicle should have the right tag to participate proportionally and on the same price and terms in any exits. Because these are purely passive investments, co-investors also will seek comfort that they won’t be bound by any restrictive covenants or asked to make any representations or warranties that are outside of their control in connection with an exit.
- Co-invest stakes are passive investments with control rights generally residing with the lead sponsor other than in limited instances, such as related party transactions where co-investors may not be perfectly aligned with the main fund. Fund recapitalizations and portfolio company monitoring fees are two common examples of a type of related party transaction where co-investors’ interests may not align with those of main fund LPs.
How do sponsors structure co-investments?
- We typically see co-investors routed through an aggregator vehicle that contains all of the core handholding, conflicts, expense, reporting and other provisions. This signs the acquisition documents at the time of the initial purchase, and similarly, signs any sale documentation. To the extent that the exit is via IPO, using an acquisition vehicle also helps with the group analysis, as the sponsor controls the acquisition vehicle and typically would make any required Section 13 filings on its behalf rather than having to coordinate with individual co-investors.
Will the SEC’s new private funds rules proposal impact co-investments?
- Likely yes. For example, co-investors typically do not want to bear dead deal risks, whether the lead sponsor’s costs in pursuing the deal or any termination fees payable under the transaction agreements. Historically, the SEC’s view has been that a sponsor need not require co-investors to bear such costs as long as investors in the sponsor’s fund were on notice as to how the sponsor might allocate such costs at the time of their investment, and most sponsors have been including such disclosure within their agreements.
- However, the proposed rule does not include an explicit exception for omitting co-invest vehicles or other co-investors from fee and expense allocations related to dead deals. Rather, the proposed rule refers only to allocation among “clients” of the adviser—so, as currently proposed, to the extent that any particular co-investor or co-invest vehicle is not deemed a client of the adviser, such co-investors would not be obligated to share in fee and expense allocations on a pro rata basis (although the SEC could try to take the position that co-investors or co-investment vehicles are clients—a position we’ve seen on one or two exams).
- That said, in the proposing release for the proposed rule, the SEC poses the question of whether the rule should apply to activities with respect to persons to which the adviser offers co-investment opportunities even if the adviser does not classify them as clients, thus leaving open the door to pull in non-client co-invest vehicles into the scope of this prohibition.
- The practical effect of this particular provision as proposed, if ultimately clear that there is no exception for co-investment vehicles, would be to prohibit non-pro rata allocations across parallel funds, co-invest vehicles, and other clients that invest in the same deal. This would be a change in practice for many firms.
This podcast is part of our Fully Invested podcast series from Ropes & Gray’s global asset management practice that provides insight into essential considerations associated with current and emerging asset management topics. To listen to the full podcast, please click here.