United States: Joining Forces To Deploy Capital: The Rise Of Private Equity Co-Investments

Co-investments, in which an LP investor invests alongside the fund in portfolio companies, in addition to through the fund, have become increasingly pervasive in private equity as fund sponsors find opportunities that they cannot pursue due to concentration limits and LP investors need to deploy capital in scale. Co-investments offer a wide range of financial and networking benefits to private equity fund sponsors and their LP investors.This article provides an overview of co-investments, their benefits to fund sponsors and investors, and some commonly negotiated co-investment deal terms.

Overview of Co-Investments

Co-investments are direct investments in a portfolio company by LP investors that are made alongside, and often on the same terms as, the fund in which the LP investor is also an investor. LPs pursue co-investments through one of the following methods: (1) investing in a fund-of-funds with a small percentage allocated to co-investments; (2) investing in a co-investment-only strategy; or (3) leveraging an opportunity through other investments with the same sponsor.

Today, co-investing is embedded in private equity business models. General partners offer co-investment opportunities not only to obtain large commitments, but also to build relationships with current or potential LP investors.

Although co-investment rights have become increasingly popular, there is a limited number of LP investors capable of executing co-investments due to the required capital and time pressure to complete the deal.

Benefits of Co-Investments

LP Investors have several incentives to make co-investments. The most common benefits include:

• Reduced or Eliminated Fees. In contrast to the investment fund structure in which the LP investors benefit from the portfolio company investment made by the fund through their LP interests in the fund in a co-investment, the LP co-invests directly in the portfolio company (typically through a special purpose vehicle managed by the fund manager), alongside the fund. Because the investment is not made through the fund, the terms and conditions of the fund documents (including management fees and carried interest) do not apply to the investment. As a result, the LP typically pays reduced or no management fees or carried interest on the investment.
  
  Funds with formal co-investment programs will generally attempt to set a fee structure at the time of the fund's establishment. With informal funds, fees will be negotiated with co-investors at the time of the investment. In either case, the overall fee package for co-investors will typically be lower than the fees charged in the main fund (e.g., 1 percent management fee and 10 percent carried-interest arrangement).
  
  
• Better Returns. Since co-investing has reduced or eliminated management fees, co-investors will have better net investment returns in relation to investing exclusively in investment funds. According to a study from ValueWalk, 80% of LPs reported better performance from co-investments than from traditional fund structures.
  
  Additionally, typically, there is a shorter period between when the co-investor makes a capital commitment and receives returns because the investment has already been identified at the time of the co-investor's commitment.
  
  
• Stronger Relationships with Fund Managers. In co-investment transactions, the investor works closely with the fund sponsor, as its partner in making the portfolio company investment. Many limited partners prefer the co-investment model because it adds transparency and trust.
  
  
• Access to Specific Portfolio Companies. Co-investment opportunities are actively sought after by LP investors and not every LP investor will be granted them. Private equity sponsors will typically limit co-investment opportunities to LP investors that make early "cornerstone" capital commitments to the fund, make very large capital commitments, or offer strategic benefits to the fund sponsor. The sponsor may reserve the right to not necessarily offer each LP investor with co-investment rights the ability to participate in each portfolio company investment in which there is a co-investment opportunity, but rather choose certain LP investors to participate in certain portfolio company investments. Correspondingly, unlike the capital committed to the fund, the LP investor is typically not required to participate in a co-investment. Once the sponsor brings the opportunity to the LP investor for consideration, the LP investor will make a case-by-case determination on whether it will participate. No reason is required for an LP declining to participate in a co-investment opportunity. Thus, the investor can invest in specific geographies, industries, or other aspects and at a specific time.
  
  
• Better Understand the Fund Sponsor's Deal Process. By working alongside the sponsor, co-investors gain insight into the sponsor's process for sourcing and selecting deals, conducting due diligence, negotiating and finalizing documentation, managing the investment, and exiting the investment.
  
  

Sponsor

• Additional Capital for More or Larger Investments. Fund sponsors can use co-investments to avoid the concentration limits and timing restrictions under their fund documents. Furthermore, co-investments permit fund sponsors to fund follow-up capital requests (1) for which the fund has insufficient capital available for call or (2) that would be prohibited under the fund documents. Participation by LP investors in a co-investment capacity provides funds with the flexibility to execute larger transactions without having to look outside their investor group for third-party capital.
  
  
• Investment Control with Passive Investors. Co-investments are typically passive, non-control investments, as the sponsor involved will exercise control and perform monitoring functions.
  
  
• Dilute risk. Co-investments enable funds to avoid excessively concentrating their invested capital in a few larger portfolio companies and achieve greater diversification.
  
  
• Specialized Investor Capabilities. Some LP investors have particular geographic contacts, industry knowledge, governmental relationships or experience, which they can provide to the fund sponsor, helping the fund consummate portfolio company acquisitions where those factors are important.
  
  
• Stronger Investor Relationships. By partnering with their most important LP investors in making portfolio company acquisitions, private equity sponsors deepen their relationships with those LPs, which can be beneficial in fundraising for subsequent funds.
  
  
• New Investors. A fund sponsor may entice new investors for its next fund by offering co-investment opportunities to LPs that commit capital early or in scale. By co-investing, investors learn how the general partner does business, performs due diligence, etc. If the LP investor has a good experience with a co-investment, in could help encourage that LP investor to to invest in the sponsor's next fund.
  
  

Some perceived disadvantages to a private equity sponsor of offering LP investors co-investment rights are: (1) sensitivity regarding providing access to the sponsor's proprietary deal sourcing and consummation methodologies; (2) differences in terms of rights of co-investors; (3) additional costs and resources; and (4) negative impact on relationships with other LP investors.

Commonly Negotiated Terms

Minority Protections

Co-investors generally have the following protections:

• Information rights.
  
  
• Pre-emptive rights.
  
  
• Tag-Along rights.
  
  

Before entering a co-investment transaction, an investor must decide how engaged it seeks to be in the co-investment. As discussed above, most co-investors are passive investors in co-investments. In such cases, investors should consider negotiating the following terms:

• Veto rights.
  
  
• Negative covenants.
  
  
• Affirmative covenants.
  
  
• Board seat or observer rights.
  
  
• Registration rights.
  
  

Relationship Terms

• Fees. Whether the investor must pay management fees and carried interest to the fund sponsor on the co-investment and whether the investor pays its pro rata portion of the portfolio company's fees to the sponsor or its affiliates for management or other services.
  
  
• Affiliate Transactions. Whether there are any restrictions on affiliate transactions between the fund sponsor or its affiliates and the portfolio company.
  
  
• Organizational Documents. Whether there are any restrictions on amending the terms of organizational documents of the portfolio company (e.g., the certificate of incorporation, bylaws, stockholders agreement or limited liability company agreement).
  
  
• Additional Transactions. Whether the sponsor has the ability to cause the co-investment entity to engage in other transactions or admit holders other than the co-investor.
  
  
• Information Rights. Whether the investor has information rights, particularly if the investor needs specific data about the portfolio company that is not provided by the fund sponsor to LP investors in the fund.
  
  
• Pre-Emptive Rights. Whether the investor or sponsor has pre-emptive rights to participate in subsequent equity financings done by the portfolio company.
  
  
• Indemnification. Whether the portfolio company is required to indemnify the co-investor for disputes with third parties and other co-investors.
  
  
• Transferability of Interests. Whether the LP investor can transfer its interests in the portfolio company and, if so, whether any such transfer is subject to a right of first refusal and/or tag-along rights in favor of the fund sponsor.
  
  

In summary, co-investments offer many advantages to both private equity sponsors and LP investors. Please don't hesitate to contact the authors of this article with any questions that you may have about co-investments.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.