Co-investment – the private equity ‘gold’
December 2014 | SPECIAL REPORT: INVESTMENT FUNDS
Financier Worldwide Magazine
Co-investment opportunities – in many cases, affording pre-sourced deal pipeline, pre-diligence deal quality and pre-negotiated deal terms – have become an ever more important right sought by investors subscribing to private equity funds. In fact, many investors view their investments in private equity funds as a means to access direct investment opportunities through negotiated co-investment rights. The terms of these co-investment rights are increasingly subject to heavy negotiations between private equity sponsors and investors. This article discusses considerations for both sponsors and investors in negotiating co-investment terms.
Allocation of co-investment opportunities
There is considerable variability in the market regarding the allocation of co-investment opportunities by sponsors. In many cases, the sponsor of a private equity fund retains sole and absolute discretion to allocate co-investment opportunities to either investors in that fund or to independent third parties. In such cases, fund investors may informally express their interest in being allocated co-investment opportunities and such expression of interest may be memorialised in a side letter. These expressions of interest typically impose no obligation on the sponsor to actually allocate co-investment opportunities to an investor in any instance.
In some limited circumstances, sponsors may be required to grant preferential co-investment rights to some (those investing over a specific threshold in the fund) or all of the investors in the funds that they manage. In such cases, once a sponsor makes the determination that a co-investment opportunity is available, it is typically allocated to ‘co-investing’ fund investors pro rata based on relative commitments. A sponsor may additionally be compelled to go through a series of ‘round-robin’ offerings of any unaccepted co-investment opportunities. Any preferential co-investment rights are subject to carve-outs for ‘strategic investors’ – third parties that may bring special value to the co-investment – whether through the sourcing of the co-investment opportunity, priority financing, or even development or technical assistance premiums. In many cases, without the involvement of such a strategic investor, the co-investment would neither be available nor economically viable.
A sponsor generally has the ability to offer co-investment opportunities (even when granted to some or all fund investors on a preferential basis) subject to timing and other conditions. And it is becoming more common for fund investors to negotiate such specific terms at the outset and set forth terms in a side letter. The negotiated terms may include the timing for when co-investment opportunities are offered, sharing of information regarding co-investment opportunities, and the relationship between the co-investment terms offered to the relevant investor as compared to those enjoyed by the fund or other co-investors. Many of these considerations are driven by increasing scrutiny with regard to whom co-investment opportunities are being offered and on what terms.
To reduce the risk that the time required for the fund’s co-investment allocation process or an investor’s approval process for a co-investment may jeopardise the investment, sponsors typically have to place time constraints on co-investors with regard to both acceptance and closing of a co-investment opportunity. Accordingly, investors may require that co-investment opportunities be offered on or before the date of approval by the fund’s investment committee or as soon as practicable thereafter.
Investors may require a sponsor to share all due diligence reports obtained from a potential portfolio company in regard to the co-investment offered. Sponsors may reasonably require a release of liability from the recipient investor regarding information obtained from third parties. Sponsors may also require that an investor share due diligence costs. Occasionally, investors conduct their own due diligence and request that the sponsor facilitate direct access for the investor to the portfolio company, its books and records, and its management. In many cases, independent access rights for an investor is not practical, either because the relevant portfolio company will not agree or because contact with the portfolio company must be streamlined to ensure successful investment negotiations.
Whether co-investment rights are offered to investors with or without management fees or carried interest generally depends on the marketing and negotiating leverage of the sponsor. In many cases, co-investing limited partners seek to negotiate whether participation in a co-investment opportunity will be subject to fees or carried interest. Even in cases where these are reduced or not charged, the costs and expenses of handling the co-investment and organising a co-investment vehicle, if any, are borne by the co-investors. Such costs and expenses may in some cases be subject to an overall or annual cap.
Terms of underlying investment
Irrespective of whether fund investors negotiate preferential co-investment opportunities, a fund sponsor is generally required to covenant that any co-investment fund (any vehicle that is managed by the sponsor or an affiliated entity to make such co-investment) is subject to the same terms and conditions as the primary fund, including the terms and timing of acquisition and disposition. For example, the primary fund documentation will include provisions mandating that such co-investments will be acquired and disposed of at the same time and on the same terms as the primary fund, subject to legal, tax, regulatory or other similar considerations.
As co-investment opportunities become increasingly important to private equity investors, funds of funds are joining the frenzy and building direct co-investment tranches into their investment strategies to lure new subscribers. There is also considerable buzz in the market regarding new private equity funds being launched with investment strategies devoted entirely to co-investments. With this increased focus on co-investment, and as more investors take advantage of the co-investment opportunities offered, we expect to see further attention on allocation rights and negotiation of specific terms by investors upon subscription to private equity funds.
Mara Topping is a partner, Anthony Wong is a local partner and Matthew Griffin is head of the London office’s investment funds practice at White & Case LLP. Ms Topping can be contacted on +1 (202) 626 3663 or by email: firstname.lastname@example.org. Mr Wong can be contacted on +852 2822 8768 or by email: email@example.com. Mr Griffin can be contacted on +44 (0)20 7532 2252 or by email: firstname.lastname@example.org.
© Financier Worldwide
Mara Topping, Anthony Wong and Matthew Griffin
White & Case LLP