What Are Co-Investments?

A co-investment opportunity is an invitation to invest alongside a fund manager’s private fund (the “Main Fund”) in a specific underlying portfolio company. While co-investments have historically been offered by private equity fund managers, they may also be offered by hedge fund managers. Co-investments are typically offered on a discretionary basis, allowing the selected co-investors to opt in or out of the opportunity. However, managers may also enter into a co-investment program with one or more investors, pursuant to which such investors are allocated a percentage of each investment opportunity entered into by the Main Fund. As described below, co-investments can be structured in a number of ways. However, for simplicity purposes, we have focused primarily on co-investments that are structured as co-investment funds that commingle a number of unrelated co-investors and invest side by side with the Main Fund in an underlying investment (either directly or through a holding company).

Why Do Managers Offer Co-Investments?

Co-investments are attractive to investors because their fee terms are typically more favorable than the fee terms offered by the Main Fund and they afford participating investors from the Main Fund an opportunity to increase their exposure to a specific investment being made by the Main Fund. Managers offer co-investment opportunities for a variety of reasons, including:

1. Bridging a Funding Gap: A funding gap may occur where the Main Fund has insufficient capital to make the full investment or its governing documents impose one or more investment restrictions that limit in some way its ownership of the underlying investment. In the case of hedge funds, the funding gap may be the result of investor withdrawals or the potential for withdrawals due to the hedge fund’s liquidity terms.
2. Spreading Risk: Co-investments allow the manager to spread the Main Fund’s risk in connection with its ownership of a particular underlying investment, while continuing to retain control over the underlying investment.
3. Providing Additional Resources/Skills: Co-investors may bring additional resources or skills to the underlying portfolio company, particularly in the case of co-investors that have expertise in the particular industry or geographic location, including other private equity managers and operating partners.
4. Building Goodwill: Co-investments may be offered in order to build goodwill with existing or prospective investors and other strategic parties.
5. Sourcing Future Deal Flow: Co-investments may be offered to certain co-investors that the manager believes will be in a position to source future deal flow for the manager or the Main Fund.
6. Building Expertise: Hedge fund managers may also offer co-investment opportunities to allow the manager to build up expertise and a track record in a strategy that is different from the manager’s other products, including investments in illiquid investments.

Who Typically Receives Co-Investment Opportunities?

Co-investment opportunities are often offered to one or more of the Main Fund’s investors, investors in the manager’s other funds and accounts, prospective investors, and third parties that the manager deems to be strategic partners (and/or, in each case, their affiliates). Strategic partners may include operating partners that will serve in an executive or other senior role at the portfolio company level or private equity firms that have expertise in the relevant industry or geographic location and/or can source and share future investment opportunities. The timing of the closing of the underlying transaction may determine the investors to which a manager will allocate any given co-investment opportunity.

Timing

Depending on the urgency in consummating the investment in the underlying portfolio company, the Main Fund and the co-investors may make the investment at the same time, or the Main Fund may acquire the entire investment and subsequently syndicate a portion to the co-investors at a later date. In each case, the co-investors must be able to act quickly to secure any required internal approvals to the co-investment and must also have sufficient capital available to fund the transaction on a timely basis. If the co-investors will be admitted through a syndication, the manager must ensure that the Main Fund’s offering documents allow it to do so and should also determine whether the portion of the investment being syndicated will be transferred at cost or, if there has been a significant time lapse between the Main Fund’s acquisition of the investment and the effective date of the syndication, whether the co-investors should be required to pay interest to the Main Fund’s investors in order to compensate them for funding the investment in full (or whether the value should be otherwise determined).

Co-Investment Structures

In general, the Main Fund will typically invest in a holding company (a “Holding Company”) that in turn holds the underlying portfolio company, but it may also invest directly in the portfolio company. A variety of structuring options are available to a manager considering offering a co-investment opportunity. The structure used will be driven by a number of factors, including the number of co-investors that will participate and any tax, legal and regulatory concerns. Managers typically create an entity to accommodate the co-investors, but in some instances may permit co-investors to invest directly in the portfolio company or Holding Company. Allowing a co-investor to invest directly in a portfolio company is often not a desirable approach for a manager, as the manager will have no control over how the co-investor exercises its rights with respect to its investment in the portfolio company. In addition, the co-investor may have economic or business objectives and goals that are not consistent with those of the Main Fund. Unless the arrangement is carefully structured, the Main Fund may be liable for actions of the co-investor, and there may be some reputational risk.

The more common approach is to create a co-investment entity in which each co-investor participates and which in turn invests in the Holding Company or portfolio company (a “Co-Invest Vehicle”). A variety of additional entities may also be included in the structure to accommodate the tax, legal and/or regulatory requirements of one or more of the co-investors (e.g., blockers to accommodate co-investors that do not want flow-through tax treatment). A Co-Invest Vehicle typically holds only one investment (which may include an initial investment and one or more follow-on investments in the same portfolio company or group), but it can — depending on the arrangement between the manager and the co-investors — hold multiple investments. A Co-Invest Vehicle with multiple investments may be cumbersome to manage and administer and introduces the risk of “cross-class liability” (where the ownership of all investments is not pro rata across all co-investors), so managers may opt for a “series” or “segregated portfolio” type vehicle that segregates the various underlying investments and seeks to mitigate the risk of cross-class liability.

As the manager will typically control the Co-Invest Vehicle and the Main Fund, it must be mindful of its fiduciary duties to both entities and any conflicts of interest that may arise. To mitigate those conflicts, managers typically agree that the Main Fund and the Co-Invest Vehicle will acquire and dispose of the underlying investment at substantially the same time and on substantially the same terms. In addition, managers typically agree that certain rights received by the Main Fund (e.g., preemptive rights, tag-along rights, information rights) will also be passed through to the co-investors through the Co-Invest Vehicle. Some managers also agree that in the event one or more co-investors do not exercise their preemptive or tag-along rights, any excess will be allocated among the other Co-Invest Vehicle co-investors that have expressed an interest in receiving a portion of any available excess.

Common Terms

The terms of any co-investment will vary depending on a variety of transaction-specific facts and circumstances (e.g., the sophistication of the co-investors, the structure used, ownership percentages). The following is a nonexhaustive summary of a number of the key terms that are typically included in the governing documents of a Co-Invest Vehicle.

1. Funding: In most cases, a co-investor will be required to fund its entire capital commitment on or about the date on which it is admitted to the Co-Invest Vehicle. This mitigates the risk of an investor default, although default provisions are usually included because most Co-Invest Vehicles are allowed to make follow-on investments, may call capital for fees and expenses, and may be required to return distributions in order to fund the investor giveback obligation (see below). The governing documents of some Co-Invest Vehicles expressly provide that amounts for fees and expenses are in addition to the co-investor’s capital commitment.
2. Eligibility: To avoid potential issues under the U.S. securities laws, Co-Invest Vehicles typically require each co-investor to represent, among other things, that it is an “accredited investor” and “qualified purchaser.”
3. Fees and Expenses: Co-Invest Vehicles typically have reduced or no management fees and carried interest (“carry”). Each co-investor typically pays its pro rata portion of the Co-Invest Vehicle’s organizational and operating expenses, which are often capped. Co-investors are typically responsible for any fees they incur while negotiating the Co-Invest Vehicle’s governing documents.
4. Giveback: Co-Invest Vehicles are typically permitted to “claw back” from all investors amounts distributed to them to the extent that the vehicle has insufficient cash to satisfy its indemnification obligations. Returnable distributions are usually limited in both timing and amount.
5. Preemptive Rights: Co-investors are typically granted the right, but not the obligation, to participate in any follow-on investments pertaining to the initial underlying investment. Some Co-Invest Vehicles allow co-investors that elect to participate in follow-on investments the option to elect to receive more than their pro rata share of such opportunity in the event that other co-investors in the Co-Invest Vehicle do not exercise their rights to participate in full.
6. Tag-Along Rights: Co-investors are typically granted tag-along rights permitting them to elect to tag along on a sale by the Main Fund of any portion of its interest in the underlying investment by requiring the Co-Invest Vehicle to tag along on such sale with respect to the electing co-investor’s indirect portion of such investment. Certain sales or transfers may be excluded (g., a sale to management or affiliates of the manager or a sale that would not reduce the Main Fund’s holding below a specified percentage of the portfolio company).
7. Drag-Along Rights: Managers typically include drag-along rights allowing them, in connection with a sale by the Main Fund of all or a specified portion of its interest in the underlying investment, to require all co-investors to sell a pro rata portion of their interests on the same or substantially the same terms. The threshold for activating the drag-along right is often the sale of 50% or more of the Main Fund’s interest.
8. Information Rights: Co-investors will often negotiate the right to receive certain portfolio company-level financial information on an ongoing basis (g., EBITDA, net debt, net revenues). Investors in the Main Fund typically do not receive the same level of information regarding underlying portfolio companies.
9. Amendments: While most amendments to a Co-Invest Vehicle’s governing documents can typically be made by the majority-in-interest of the co-investors, co-investors will often seek to negotiate the right to block any amendment that would adversely affect certain of their rights or obligations. This may include changes to a co-investor’s preemptive, tag-along/co-sale and information rights; giveback obligations; the ability to disclose confidential information to its investors, prospective investors and other parties; any increase in its economic obligations or liability; or any reduction in its right to receive allocations or distributions.
10. Removal of the General Partner/Manager: A Co-Invest Vehicle will typically have the same manager and general partner (in the case of a partnership) as the Main Fund. Most Main Funds allow for the removal of the manager and general partner if a “cause event” occurs and may also provide for a “no fault” removal at the election of a specified percentage-in-interest of the investors. Although some managers will mirror the removal-related terms of the Main Fund in the Co-Invest Vehicle’s governing documents, it is more common to provide that if the manager/general partner is removed or resigns from the Main Fund, they will also be removed or deemed to have resigned from the Co-Invest Vehicle (although the terms of the Co-Invest Vehicle may provide that a majority-in-interest or other specified percentage-in-interest can override the automatic removal). It is also common to provide that the Main Fund’s replacement manager/general partner will also be appointed in a similar capacity to the Co-Invest Vehicle.
11. Broken Deal Expenses: Broken-deal expenses are expenses that are incurred by a manager or Main Fund in reviewing/negotiating an underlying investment that is never consummated. The main ways in which they are generally dealt with are as follows: (i) the manager bears the full amount; (ii) the Main Fund bears the full amount; or (iii) they are shared in a pre-agreed proportion by the manager and the Main Fund. Things are more complicated if a Co-Invest Vehicle is also involved, because co-investors are generally not on the hook for expenses until they are admitted to the Co-Invest Vehicle, which typically does not happen until around the time that the deal is consummated. In such a scenario, the co-investors are typically not required to pay a portion of the broken-deal expenses unless they have otherwise agreed to do so (g., as part of an equity commitment letter or other agreement). The allocation of broken-deal expenses is subject to heightened regulatory scrutiny by the U.S. Securities and Exchange Commission (SEC) and should be approached with caution. A manager should have a clear policy on how broken-deal expenses will be allocated, and such policy should be clearly set out in the Main Fund’s offering documents.
12. Registration Rights: While demand registration rights allow the holders of a certain percentage of registrable securities to require that the company register its shares after a certain period of time, piggyback registration rights enable holders of registrable securities to participate in the registration of any other class of shares by the company. As co-investors are often minority holders (individually and in the aggregate), piggyback registration rights are more common in the co-investment space.

Key Differences Between Co-Invest Vehicles and Main Funds

While there is usually significant overlap in the terms offered by a Main Fund and its related Co-Invest Vehicle (e.g., default provisions, limited liability, giveback obligations for indemnification purposes, confidentiality), there are also a number of key differences, which are as follows:

1. Number of Investments: Main Funds typically have diverse portfolios with multiple investments, sometimes across a range of industries, markets and geographic locations. Co-Invest Vehicles will often only have one investment (or may have multiple investments in the same target company/group).
2. Participation in Investments: Main Funds typically operate as a blind pool where the manager makes the investment decisions and all investors participate in each investment on a pro rata basis (although excuse and exclusion provisions are common for investors with specific tax, legal or regulatory concerns). Co-investors are usually permitted to review certain information related to the underlying portfolio company in advance and elect to invest or not (and may be allowed to perform detailed due diligence on the portfolio company).
3. Capital Calls: Investors in most Main Funds are required to fund capital calls during the prescribed term. The investment-related capital contributions to Co-Invest Vehicles are usually fully funded upfront. Co-Investors may be required to fund additional amounts during the life of the Co-Invest Vehicle in order to pay fees and expenses that arise, but those amounts are often minimal.
4. Management Fees and Carry: Co-Invest Vehicles are typically subject to reduced or no management fees and carry. Investors in the Main Fund typically pay full fees (unless they are in a position to negotiate a lower fee or carry rate through a side letter). If a co-investor in a Co-Invest Vehicle is also an investor in the Main Fund, the preferential fee terms at the co-invest level will reduce the overall expense ratio of the investment in the Main Fund. If the co-investors are subject to management fees and/or a carry in respect to their investment in a Co-Invest Vehicle, it is usually calculated in a similar manner to the Main Fund, but often at a reduced rate. To the extent that a co-investor invests in two or more separate Co-Invest Vehicles that invest alongside the Main Fund, there is no ability to offset any losses incurred by one Co-Invest Vehicle against the gains made by another Co-Invest Vehicle when calculating any carried interest payable in the event that some are successful but others are not. Depending on how the carry is structured at the Main Fund level, investors may be able to offset such amounts to a degree if the carry is calculated on a fundwide basis.
5. Reporting: As noted above, co-investors will often negotiate the right to receive certain portfolio company-level information on an ongoing basis. Investors in the Main Fund will typically not receive the same level of information.
6. Term: A Main Fund will typically have a definitive term that may be subject to a limited number of extensions under certain circumstances. A Co-Invest Vehicle usually will be liquidated once its investment is disposed of.
7. Management Fee Offsets: A Main Fund will typically provide that all or a high percentage of transaction fees, monitoring fees, directors’ fees and similar fees received by the manager and its affiliates in connection with the Main Fund’s underlying investments will be offset against the management fee that would otherwise be payable by the Main Fund (the same is often the case for placement fees and organizational expenses in excess of a specified amount). In the case of a Co-Invest Vehicle that does not pay management fees, this offset will not apply.

Risks of Co-Investments

Co-investment opportunities can entail a number of risks for both the manager and the co-investors. To mitigate the risks applicable to the manager, it should implement and enforce robust co-investment-related policies and procedures. It should also ensure that such policies are described in sufficient detail in the offering documents for the Main Fund (and other products offered by the manager) so that investors in those entities are aware of how co-investment opportunities are allocated. In addition, a manager can seek to mitigate reliance risk by providing prospective co-investors with sufficient information so that they can adequately evaluate the opportunity if they choose to do so. Managers will typically require that the co-investors sign confidentiality agreements prior to providing them with confidential information related to any investment.

Co-investors will be subject to a broad range of risks, including those related to the industries, markets or geographic locations in which the underlying portfolio companies operate. In addition, Co-Invest Vehicles are by their nature highly concentrated, as they usually hold one investment only, resulting in concentration risk.

Allocation of Co-Investment Opportunities/Compliance Policies and Procedures

Managers seeking to offer co-investment opportunities should develop and implement robust co-investment policies and procedures as an internal road map to be used in the allocation of investment opportunities (a “Co-Investment Policy”). A typical Co-Investment Policy will include, among other items, (i) the scenarios in which co-investment opportunities will be offered (e.g., when the Main Fund’s investment program or other factors prevent it from acquiring the entire underlying investment (or increasing its participation in a specific investment beyond a specified level)); (ii) the types of investors to whom co-investment opportunities will be offered and, if applicable, the order of priority in which they will receive such opportunities; (iii) the manager’s approach with respect to the disposition of the underlying investment (i.e., whether it is intended that the Main Fund and the Co-Invest Vehicle will acquire and dispose of the underlying investment at substantially the same time and on substantially the same terms) and, where applicable, the ability to deviate from that policy; (iv) the policy with respect to the allocation of fees and expenses, including deal expenses, broken-deal expenses and transaction fees, attributable to the underlying transaction; and (v) in the event that the Main Fund will acquire the entire investment and subsequently syndicate a portion to co-investors, the policy regarding the price at which the co-investors will acquire its portion of the underlying investment (including any interest payment, if applicable).

The manager should also develop a list/description of the factors to be considered when offering co-investment opportunities to prospective co-investors (the “Investors”), which may include one or more of the following:

1. Interest: Who has expressed an interest in receiving co-investment opportunities, either generally or with a focus on a specific industry, market or geographic location.
2. Suitability: Whether the underlying investment is suitable for the Investor, and whether the Investor will bring any strategic value to the underlying portfolio company.
3. Timing: How quickly an Investor can conduct its due diligence, negotiate any documents and fund its portion of the underlying investment.
4. Obligations: What obligations the manager or its affiliates have in place already with respect to co-investments (g., through side letters and disclosures in offering documents).
5. Other Factors: Any other factors that the manager deems to be relevant, with respect to either a specific Investor or a co-investment opportunity.

The Co-Investment Policy should be clearly and adequately disclosed in the manager’s Form ADV (in the case of a manager that is registered with the SEC as an investment adviser). In addition, the Co-Investment Policy should be consistent with any side letters or other arrangements regarding co-investments. The manager should also ensure that the offering documents for the Main Fund and other funds contain adequate disclosure regarding the manager’s policy on co-investments. In the case of a subsequent syndication by the Main Fund, the manager should ensure that this approach is consistent with the provisions of the Main Fund’s governing documents.

Conclusion

Access to co-investment opportunities continues to be highly sought after by a wide range of investors. At the same time, the legal and regulatory landscape continues to evolve, with the SEC continuing to scrutinize many aspects of fund managers’ businesses. In order to reduce the associated regulatory risk, managers should ensure that they have comprehensive policies and procedures in place to evaluate, allocate and monitor co-investment opportunities.