Alternative Insight – May 2019

Behind the co-investment curtain: current “market” terms revealed

 

Co-investments are now an integral part of the private equity funds market, popular with GPs and LPs alike. In a classic co-investment, an investor is invited by a GP to make a separate, additional investment in a target company (the Target) alongside the main investment being made by the GP’s fund (the Sponsor Fund). Co-investors may acquire the Target’s shares directly, or their exposure to the Target may be indirect, through a co-investment vehicle (the CIV) run by the Sponsor Fund’s GP. The CIV may be dedicated to just the one deal, or it may be a standing vehicle making multiple co-investments.

Although CIVs resemble mini-funds (indeed, they are often structured as limited partnerships, with the Sponsor Fund GP serving as general partner), they are heavily customised for the co-investors and investment(s) in question, and differ from conventional blind pool funds in several aspects:

Management fees

GPs use co-investment opportunities as a way to cement and grow the relationship with key LPs in their existing funds. That’s one reason why management fees on co-investments are kept comparatively low – typically 0.5% to 1% of committed capital, invested capital or net invested capital, per year, as against the 1.5% to 2% seen in conventional blind pool funds. Some CIVs are fee-free, or only charge fees to co-investors who are not LPs in the Sponsor Fund.

Target fees

Even in a zero-fee vehicle, the GP may be able to take (without an accompanying offset obligation) one-off transaction and annual monitoring fees from the Target directly, which together comprise a de facto management fee. Co-investors (particularly if they are LPs in the Sponsor Fund, which can be expected to have its own complete or partial fee offset) typically negotiate to prohibit Target-level fees or, if they are commercially justified, to fix or cap them.

Carry

Like fees, CIV carried interest is invariably lower than in blind pool funds. We usually see co-investment carry in the 5% to 15% range. Ratcheted carry is increasingly popular: the carry rate moves up or down in line with total cash returns to co-investors. If the GP earns substantial fees from the CIV, then there may be zero carry. If co-investors pay carry, then they will benefit from a hurdle – generally, 6% to 8%.

Expenses

Transaction-related expenses (with the possible exception of abort costs; see below) are apportioned between the Sponsor Fund and the co-investors in line with their investments in the Target, whereas the CIV’s own setup and operating expenses are generally met entirely by the co-investors. Expenses may be drawn down from co-investors’ capital commitments, as in a mainstream fund, or they may be structured as an add-on liability (i.e., on top of commitments). Expenses are often capped – indeed, this is essential if they are an add-on liability, which would otherwise be open-ended. Placement agent fees are rare in the context of co-investments. If at all incurred, it is established market practice that they are borne by the manager alone, not the co-investors.

Abort costs           

Deal-specific CIVs typically admit co-investors near the end of the transaction, when there is a low probability that the deal will collapse. If it does collapse, the CIV is unlikely to have ever seen the light of day. In that case, abort costs (essentially, the costs of due diligence by legal counsel and other advisers incurred before a proposed transaction collapses) would in all likelihood be wholly met by the Sponsor Fund, not the prospective co-investors.

This practice, although common historically, was not always clearly disclosed to LPs either before or after they joined the Sponsor Fund. A number of high-profile regulatory enforcement actions and settlements in America during and since the Obama years brought greater investor and public attention to the issue. In the current generation of funds, virtually all GPs disclose their allocation policy for abort costs in the LPA and/or PPM.

This comes in three main flavours:

  • The most common, even among new-vintage funds, is to give the GP clear discretion to allocate abort costs, including the ability to book them all in the Sponsor Fund.
  • The main alternative (which is steadily gaining ground and is now the second most common policy in new-vintage funds), broadly speaking, requires the GP to apportion abort costs between the Sponsor Fund and prospective co-investors on a pro rata basis. To make this work in practice, the GP needs to get contractual undertakings from prospective co-investors that they will pay their fair share of abort costs.
  • Very occasionally, one will see an outright cap on the Sponsor Fund’s aggregate liability for abort costs.

GP commitment

GP commitments are exceedingly rare in a classic co-investment vehicle, if only because the management team is investing concurrently in the Target via the existing GP commitment in the Sponsor Fund, and thereby has ‘skin in the game’, believed to align the team’s interests with those of its investors.

Further co-investors and follow-ons

Single-deal CIVs generally do not admit new co-investors in the future except with the consent of existing co-investors or where the latter have passed on the opportunity to increase their commitments in the CIV in order to fund follow-on investments. Existing co-investors will effectively be diluted (at the Target level) if they don’t participate in follow-ons on a pro rata basis with their original co-investment.

Minority investor protection

An investor whose sole exposure to the Target comes through its limited partner interest in the Sponsor Fund does not actively ‘choose’ the Target, but a co-investor does. Moreover, if a big chunk of the acquisition is financed by co-investment, then the co-investing LPs are really more like minority shareholders in a joint venture. This raises an additional set of considerations which impact on the terms of the CIV’s LPA.

As an overriding principle, they should want the CIV to be treated pari passu with the Sponsor Fund – investing in and divesting from the Target at the same time and on the same terms. This can be reinforced by tag and drag rights in the Target shareholders’ agreement.

Co-investing LPs may also push for ‘pass through’ reserved matters on Target finances and activity. These may include things like adding or refinancing debt, diluting the CIV’s stake in the Target by issuing new shares, material amendments to the shareholders’ agreement, etc. The GP (which ultimately controls the Target by virtue of its control of the combined shareholdings of the Sponsor Fund and CIV) agrees not to undertake any reserved matter without co-investors’ consent.

Co-investors may also seek regular performance reports and copies of Target board packs. A dominant LP co-investor may have sufficient sway to have one of its representatives attend meetings of the Target’s board as an observer.

We explore many of these issues in more depth in the MJ Hudson Private Equity Co-Investments Manual.