Conflict over co-investment terms

Private equity co-investment has soared in popularity in recent years. The real scale of such an opaque market can be hard to judge, but typical estimates fall in the $55 billion-$60 billion annual dealflow range. LPs have been clamoring for direct investment opportunities in a bid to gain alpha, often citing the lure of a no-fee, no-carry option.

Despite overwhelming appetite from LPs, however, the share of managers that offer co-investment has fallen from 87 percent two years ago to 75 percent in 2020. This could reflect an SEC push on transparency about the way that co-investment opportunities are shared and how transaction fees are divided between co-investors and the fund itself.

“The need to treat every LP fairly may mean co-investment has become more trouble than its worth for some,” says Tom Angell at Withum.

“If you have 50 investors in your fund and you have to offer all of them a co-investment opportunity, and then some don’t get back to you in a timely manner, that hinders your potential to do the deal. Prior to the SEC’s involvement, you could simply go to a few of your larger institutional investors and get a quick response. It may simply be too difficult for smaller managers to comply.”

In addition to fairness and transparency, the way in which broken deal expenses are shared between co-investors and flagship funds has become one of the hottest issues for the SEC in recent years. This is particularly contentious, of course, when the co-investors in question are the individual general partners themselves. In 2015, KKR was charged with misallocating $17 million of broken-deal expenses to its flagship private equity fund. Two years later, Platinum Equity Advisors paid a $3.4 million fine after charging three of its private equity fund clients broken deal expenses that should have been borne by co-investors.

The SEC is less concerned about how broken-deal expenses are allocated between fund and co-investors – although it has insisted that investors are “treated fairly.” The emphasis, however, has been on ensuring fund managers make policies clear and stick to them. For example, Platinum’s limited partnership agreement allegedly did not disclose that funds would be required to pay broken-deal expenses for the portion of each investment that would have been allocated to the co-investor. And managers have been urgently tightening up documentation in the wake of these eyewatering fines.

But while transparency around broken-deal cost attribution may be increasing, the attribution itself has changed little. A total of 58 percent of respondents to the Private Funds CFO Fees & Expenses Survey this year said they did expect co-investors to bear proportionate costs of broken deals, either if a co-investment entity has been formed – ie, if the deal had broken down between signing and closing – or because they considered a willingness to take on costs to be part of their indication of interest regarding the co-investment. This compares with 53 percent in 2018 and 57 percent two years earlier.

Similarly, the proportion of managers that do not charge broken-deal expenses to co-investors simply because they already charge a co-investment fee to compensate for such eventualities has remained fairly constant – registering 10 percent this year. And the proportion that do not charge co-investors broken-deal fees also holds steady at about one third. Indeed, despite the SEC having to take a hard line on co-investment and broken fees, it is clear the issue remains controversial. “This is contentious because certain deals would only proceed with co-investors, but co-investors, on a one-off basis, will not sign up for expenses until very late in the process, if at all,” says Blue Wolf Capital’s Joshua Cherry-Seto.

“This is an important issue to cover clearly in LPAs to ensure it is understood that co-investment is a cost of doing business and therefore generally borne by the main fund. Maybe there should be consideration to the fund versus the co-investment for taking the investment risk, but the market demands pari passu treatment currently.”

“Here is the deal,” adds Blinn Cirella of Saw Mill Capital. “A broken deal is a deal that was never consummated. Let’s say you have two co-investors who are investing $25 million each and the fund is investing $30 million. The deal breaks and the costs are $600,000. If these costs are shared based on the intended investment split – that would mean each co-investor would be on the hook for $187,500 and no investment to show for it. Whoever agreed to that deal is going to lose their job.”