Alternative Insight – October 2017

Co-Investments: Beware the Bear Traps!

A co-investment is where an LP makes an additional, separate investment in a target company in parallel with the main investment made by a fund (the Sponsor Fund) in which, oftentimes, the LP is itself an investor.

The popularity of co-investing has surged in recent years. Co-investments enable the GP to make investments which it might otherwise have had to decline, for instance because of concentration limits in the Sponsor Fund. At the same time, LP co-investors obtain enhanced access to selected Sponsor Fund portfolio companies, generally at lower cost compared to the LPs’ own investment in the Sponsor Fund or if the LP sourced and completed the deal on its own. However, co-investing is not without risks.

Here are seven top tips for GPs and LPs to bear in mind when making co-investments:

1. Clarify the rationale for co-investing in the deal

Unlike a multi-asset fund, which aims to reduce risk through diversification, a co-investment increases the co-investing LPs’ concentration risk. Therefore, a prospective co-investor shouldn’t simply be persuaded by the fact that the Sponsor Fund is investing in the same deal. It should consider why any given target is up for co-investment. For instance, is the Sponsor Fund constrained by concentration limits? Or might it be that the GP doesn’t rate the target as highly as others but wishes to deploy capital quickly before the Sponsor Fund’s investment period runs out?

2. Ensure GP capacity

Co-investments allow the Sponsor Fund GP to expand the pool of capital at its fingertips. But the GP should beware the risk of becoming overstretched if this allows it to close more and bigger deals than it can manage effectively given its experience and team resources. Moreover, co-investments add materially to the GP’s burden – new vehicles have to be formed, their terms negotiated, co-investors have to be able to execute in the same timeframe as the GP itself, and the co-invest vehicle will then need to be operated until the investment is finally liquidated, probably several years later. No GP should feel compelled to offer co-investment opportunities merely to appease its LPs or mimic its competitors.

3. Responsibility for and reliance on due diligence

The GP would expect to lead the due diligence review and the negotiations with the seller. Co-investors’ involvement in these activities varies from deal to deal. Some co-investors demand (or are invited to play) an active role – for instance, when a co-investor’s stake is expected to be relatively large, or if it is effectively a strategic partner for the Sponsor Fund because it has specialist knowledge of the target’s industry.

But due diligence is often expensive, and deal timescales are generally quite compressed. This means that co-investors often end up relying on the work done by and for the GP. In that scenario, they should try to obtain written assurances from the GP and its advisers, without which they are unlikely to have recourse to the GP.

4. Building LP capability

Managers need co-investors to have the skills, capital and capacity to respond quickly and flexibly in acquisition situations. But an LP’s principal business is to select funds to invest in, and that requires a markedly different skill set compared to a GP’s business of evaluating, buying and selling companies.

A seasoned co-investor will eventually need to build out a direct investments team. But this takes time and money. Some LPs, such as state-run pension funds, may face constraints on how much they can pay staff, which makes it difficult to recruit top-quality talent from investment banks or major PE firms. Co-investors without an experienced team in place may nonetheless be able to resolve the conundrum by engaging an external financial adviser to help them with the ‘heavy lifting’ of due diligence and transaction management.

5. Allocating deal expenses

Ordinarily, the co-investment vehicle will bear its own expenses, as well as its share of all investment-related expenses alongside the Sponsor Fund. However, the situation is not quite so clear-cut if the deal aborts before completion. Early stage work on a deal often begins before a co-investment strategy takes shape, and deals often die before the GP has signed up potential co-investors or formed a co-investment vehicle.

However, co-investors cannot simply assume that the Sponsor Fund will pick up broken-deal costs, unless the Sponsor Fund’s own investor documents clearly provide for this. Co-investors may be responsible for some proportion of broken-deal costs, which will be driven by several factors, including whether the co-investment opportunity is offered at the same time as the Sponsor Fund or after it, and how early or late in the due diligence process potential co-investors are notified and agree to participate.

The GP should have allocation policies and procedures in place and apply them consistently to ensure that all LPs, whether co-investing or not, don’t pay more than their fair share of expenses in the context of any co-investment, actual or aborted.

6. Striking a balance on fees

The GP generally charges reduced (or zero) management fees and lower carried interest in a co-investment vehicle compared to a conventional private equity fund. A big private equity firm won’t be too concerned by the implicit ‘loss’ of fee income, because of the fees and share-of-profits it earns from its existing conventional funds. But emerging GPs would feel the lost revenue more keenly, particularly if co-investments end up comprising a big proportion of assets under management. The two sides should aim to strike a balance between making lower-cost co-investment opportunities available to the investor base and the need to adequately remunerate (and thus motivate) the GP in the longer term.

7. Clarity on offsets

In some co-investments, the GP and its affiliates may aim to recoup ‘lost’ management fees by charging transaction, monitoring, arrangement and directors’ fees at the portfolio company level. Measured by their impact on investor returns, these charges constitute de facto management fees. Co-investors should ensure full disclosure and either pre-approval or offset of all such charges. To avoid double-counting and inadvertent omissions, it will often be necessary to link these arrangements to any management fee offset applicable at the Sponsor Fund level.


 

USEFUL GUIDES

Private Equity Co-Investments: The Manual

For further analysis on co-investments, including a survey of key terms, structuring considerations, and legal and tax issues, please download MJ Hudson’s guide, written in conjunction with EY and BDO.

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