Fifty shades of co-investing

PE Manager revisits some of its best guest articles of 2013: In February, Debevoise and Plimpton trio Stephen Hertz, David Iozzi and Andrew Rearick take a look at several of the most commonly and hotly negotiated issues in these types of transactions.

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 standardized, 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.

And while co-investments offer their participants 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. Here we discuss a few of those challenges:

Affiliate transactions: Co-investors often worry that post-closing transactions between the target and affiliates of the lead investor can represent an open “back-door” opportunity for sponsors to extract value from the target without sharing it with co-investors, whether it is through preferential consulting or management arrangements, lending, transactions between the underlying target, on the one hand, and a separate entity owned by the lead sponsor, on the other hand, or by other means. Accordingly, broadly speaking, co-investors often take the position that all affiliate transactions should be subject to minority consent (again, typically on the basis of a majority of the securities held by all co-investors). Many lead investors are quite resistant to any such restrictions, however, whereas others may consider accepting such a limitation subject to carve-outs for pre-agreed consulting arrangements, transactions conducted in the ordinary course of business, consistent with past practice, or transactions on arms’-length terms (established in a variety of different ways on a deal-by-deal basis).

Creating exit incentives: Co-investors will typically have little, if any, control over exit opportunities, but will seek to maintain economic alignment by including low-threshold or no-threshold tag-along rights and piggy-back rights in the investor agreement. Conversely, lead sponsors will also seek low-threshold or no-threshold drag-along rights, IPO rights and other orderly sale provisions in their favor. Exit provisions typically also stipulate the type(s) and mix of consideration acceptable to co-investors as well as negotiated limitations on warranties, indemnities and exit cost-sharing. Lead investors and co-investors sometimes have differing views as to what type of exit event should lead to the termination of the rights of the co-investors under the governance arrangements, with sponsors typically seeking earlier sunset triggers (e.g., any IPO of any kind) and co-investors often wanting to preserve their negotiated investor rights (or at least a sub-set of them) until a more complete exit by the sponsor.

Most favored nation: In a co-investment that is structured as a sponsor-controlled limited partnership, co-investors often have more circumscribed options to maintain alignment with the sponsor. Co-investors in such an indirect structure can still seek to achieve the same kinds of controls outlined in the bullets above, albeit this is generally through limited partner consents for certain actions to be taken by the general partner. But, because a limited partnership agreement can be modified by individual side letters between the general partner and specific limited partners that may not be known to other limited partners (in contrast to a shareholders agreement, which is typically visible to all shareholders), one of the key provisions to ensure desirable and predictable outcomes of negotiations on fundamental governance and economic points is a “Most Favored Nation” (MFN) clause. As with structuring, the type of MFN agreed upon can have a significant impact on outcomes. Some sponsors favor a “commitment based” approach (i.e., the rights offered to co-investors vary based on the level of their commitment) similar to what one might use in raising a main private equity fund. Co-investors tend to prefer a “rights-based” approach (i.e., any preferential rights offered to one co-investor must be offered to other co-investors who have negotiated an MFN clause), though depending on appetite for control and maintaining the limited liability status, co-investors may agree to limit their MFN to rights impacting economics or other issues of particular import to them.

Expenses: Although rare, and frequently resisted by lead sponsors, some co-investors invoke the alignment of economic interests principle to seek reimbursement of expenses incurred in connection with the initial investment, add-on investments and/or exit transactions to the same extent the sponsor’s expenses are reimbursed, or alternatively, agreement that each party bear its own expenses.

Reporting obligations: A co-investor also typically ensures that it has information rights to allow it to (1) meet its tax filing requirements, (2) monitor its investment and (3) distribute information about the target’s performance impacting the co-investor’s investment to its own investors (which may require exceptions to confidentiality provisions in the governing documents).

Note also that sponsors and their advisors should carefully assess corporate law minority protections, which will vary based on entity type and jurisdiction, as these may afford co-investors greater power at critical junctures than the parties generally contemplate in the deal documents, e.g., through per capita voting procedures or super majority voting requirements.

Given the varying shades of these types of co-investment deals, the tactical approach to negotiations of them can be as important as the inherent negotiating leverage and substantive precedents of the various parties. This is particularly true given the typical negotiating dynamic, in which the relationships between a sponsor and co-investors are usually multi-dimensional and not limited to simply a one-off co-investment transaction and each co-investor negotiates the co-investor related arrangements with the lead sponsor separately.

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. Part one of this two part series, which discusses structuring and due diligence challenges in co-investments, originally appeared on in January.