Fifty shades of co-investing

Structuring and due diligence challenges are discussed by Debevoise and Plimpton trio Stephen Hertz, David Iozzi and Andrew Rearick in part one of this two part series on co-investments.

Co-investment transactions have become increasingly popular as investors search for yield. Unlike club and consortium deals among private equity sponsors, or even between private equity firms and strategic partners, in which the terms of the arrangements have become increasingly standardised, co-investment transactions come in many different shades, depending on the equity splits between a lead sponsor and the co-investors (who typically hold in the aggregate 10-25 percent), the identity of the co-investors (e.g., limited partners of a lead sponsor, other private equity firms with different profiles, or even strategic investors), and a variety of other factors including deal origination, sector expertise and the jurisdictions of the co-investors.

Co-investment transactions serve a number of important purposes for their participants. For lead sponsors, co-investors can help plug holes created by tight debt markets, reduce risk exposure, and/or bring additional industry or regional expertise or simply a brand-name to an investment. They can also serve as an important tool to build and cement a lead investor’s relationships with third parties, particularly with a sponsor’s limited partners. For co-investors, these opportunities offer diversification, a chance to achieve better net investment returns and the acceleration of capital deployment. They also can help deepen institutional relationships and give the co-investor the opportunity to piggy-back off of the insight and expertise of the lead investor.

But, while co-investments offer their participants these various benefits, they also present some unique challenges for deal participants, as each is bespoke, and there is no one-size-fits-all template for the governance arrangements in these transactions. Opportunities for creative structuring abound. This article is the first installment of a two-part look into some important process matters and common issues that arise in these types of deals and the typical negotiating positions of sponsors and co-investors on these issues.

Structuring: It is in the interests of both lead sponsors and prospective co-investors to consider carefully and clearly communicate their expectations for a co-investment opportunity before any definitive documentation is produced. Initial discussions of the proposed structure of a co-investment often represent a good early opportunity for sponsors and prospective co-investors to determine how their expectations are aligned.

A sponsor typically sets up co-investment programs on a deal-by-deal basis. Depending on the size of the investment and anticipated number of co-investors, a sponsor may be more or less flexible in accommodating structuring or other requests from individual co-investors. The potential iterations that a sponsor may choose from are varied, e.g., a single sponsor-controlled limited partnership that will invest in the sponsor’s acquisition vehicle, a series of sponsor-controlled limited partnerships each holding the interests of individual co-investors, direct investment by co-investors into a sponsor’s acquisition vehicle or some combination of the above.

From a sponsor’s perspective, the structuring of a co-investment is important to enable it to dictate the 'rules of engagement'

From a sponsor’s perspective, the structuring of a co-investment is important to enable it to dictate the “rules of engagement” for co-investors and manage expectations of the respective roles of the sponsor and co-investors in the governance of the investment. From a co-investor’s perspective, while it cannot (except in highly unusual circumstances) dictate structure, it should review any proposed structure to make a judgment promptly as to whether it meets the co-investor’s tax needs (an important threshold question) and whether it is likely to set its expectations in terms of minority investor protections, post-closing funding obligations and exit options. Co-investors may also want to consider a sponsor’s ability to change the structure in the future, and whether such changes would be acceptable (e.g., continue to meet the co-investor’s tax needs).

Diligence and documentation: Trust, but Verify. In a typical co-investment process, co-investors do not have the opportunity to (or may not want to devote the resources to) conduct their own fulsome due diligence on an acquisition target and instead must (or may choose to) rely on the sponsor’s diligence. Co-investors considering an equity co-investment or syndication will typically, though not invariably, wish to review the lead investor’s formal diligence materials (e.g., professional advisors’ reports), and also have the opportunity to evaluate the sponsor’s experience with, and approach to, the diligence process, so that co-investors are able to get comfortable not therefore, likely to take the position that a sponsor should not be able to alter those agreements without co-investor input (again, typically on the basis of a majority of the securities held by all co-investors). A sponsor will typically seek carve-outs to such restrictions to the extent any alteration does not materially or, alternatively, materially and disproportionately, impact co-investors (sometimes as compared to the lead sponsor only) and other carve-outs that allow it to implement other specific transactions otherwise permitted by the co-investor agreements, such as raising distressed capital, taking a target public or effecting a sale or liquidation of the target.

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To be published in early February, the second installment of this article will highlight several of the most commonly negotiated issues in co-investments, in particular affiliate transactions, exit incentives and most favoured nation provisions.

Stephen Hertz is a partner and David Iozzi an associate in the New York office of Debevoise & Plimpton. Andrew Rearick is an associate in the firm’s London office. A version of this article originally appeared in the 2012 summer/fall issue of the Debevoise & Plimpton Private Equity Report.