Co-investments: Identifying the risks

Limited partners on the hunt for amplified returns and minimised fees have increasingly looked to capitalise on co-investment opportunities with fund managers. But what may seem like a ‘simplified’ private equity transaction that lets LPs participate directly in a deal can actually present a host of legal and operational risks. 

Institutional investors to have recently illustrated today’s demand for co-investments include the New Jersey State Investment Council, which slotted $75 million for co-investments alongside a $100 million commitment to Roark Capital Group earlier this summer. Around that same time GSO Capital Partners had rounded up a group of co-investors to capitalise on the dislocation in Europe, investing $430 million in cement business Giant Cement and its owner, Spanish cement producer Cementos Portland Valderrivas.

“The GP may have the discretion under the private placement memorandum to offer co-investment rights only to early investors in the hope of securing a speedy first closing. However, other significant potential investors in the fund are likely to ask for a MFN side letter, and as a result will also enjoy co-investment rights, even if they invest at a later stage,” says David Baylis, a fund structures-focused partner at law firm Norton Rose.

Even without a “treat all your LPs equal” clause, GPs may still be subject to the principle under limited partnership law. In most jurisdictions GPs must act in the “utmost good faith” of the fund, a pledge that could be violated when certain privileges are made exclusive to some LPs and not others.

At the very least GPs should be aware of their transparency obligations when restricting co-investment opportunities to select LPs. “If a GP offers certain investors a preferential deal, and even if the constitution of the fund gives the GP the discretion to do that, they will have to be disclosed if an investor requests an MFN side letter,” says Baylis.

LOGISTICAL RISKS

Aside from legal risks, private equity firms must also be careful which LPs are offered co-investments from a pure operational standpoint.

Despite the growing number of LPs who now jump at the opportunity to review a co-investment opportunity, the number of LPs that can actually effectively execute these arrangements is a much smaller number, says Kate Simpson, who shares her experiences as a private funds lawyer at law firm Proskauer.

“Most co-investors want to understand what they are buying, and as such you have to have deal expertise in your business to do so, and they also have to be able to move very quickly,” she elaborates.

SL Capital’s Graeme Gunn, a fund of funds manager, and serial co-investor, elaborates on the point saying that “of the (for example) 20 LPs who want co-invest opportunities, and indicate this to the GP, you might find three or four who can genuinely deliver in what is normally a tight time frame. Also the GPs will want to believe that the co-investor LPs they have alongside them have the right team and resources, are credible, understand the business and the risks and are willing to support them going forward”.

But with this co-investing capability also comes influence. The draw for GPs to do co-investments, other than the appeal it offers during fundraising, is that they can increase their deal making bandwidth. The extra cash that the co-investor puts up can make the difference in a deal normally just beyond a GP’s reach. But, as outlined before, having to rely on an investor to complete a deal has its own difficulties and risks.

WORKING WITH LPS

One such risk is the drag on a GPs’ envisioned transaction timetable in light of LPs taking a more hands on approach to the deal’s execution. In response to this GPs have been careful to maintain the basic agreements outlining their delineated powers contained within the limited partnership agreement, minus the relevant fees, when structuring a co-investment deal.

But while structuring the co-investment like this sounds simple in practice, it can be difficult as some LPs may not be legally allowed to relinquish the same level of discretionary management to the GP under a co-investment arrangement.   

Under the US Employee Retirement Income Security Act (ERISA) for example, funds with more than 25 percent of their assets from US pension plans must heed certain regulations when offering co-investments.

US pension plans covered by the law that co-invest must retain fiduciary responsibility for investment strategy, asset allocation and prudent selection and monitoring of the fund manager; all of which makes it near impossible to leave full discretionary rights to the GP. 

In order to get around this hurdle a co-investment can be structured as a Venture Capital Operating Companies (VCOC). A fund is a VCOC when at least 50 percent of its assets are invested in companies where it has management rights and the fund manager regularly exercises these management rights for at least one its portfolio companies.

A GP unable to preserve their complete control over the dealmaking process may find it an uncomfortable adjustment. Having to provide LPs access to due diligence documents like sale purchase agreements and the GP’s own notes and analysis of the deal can be uncharted waters in the GP’s investor relations approach. Tensions can reach a boiling point when some investors go a step further in requesting access to the target company’s management team.

One specialist co-investment firm that tries to appropriately balance GP control with its own due diligence needs is Stockwell Capital. “We have board visitation rights, information rights and our own investment team keeping an eye on the deal. But we don’t actively get involved in the company’s day-to-day operations,” says Stockwell’s chairman and chief investment officer of co-investments, David Evans.

Sources say that GPs understand the need for lead investors to have access to management teams, but that adding new faces to a company board (who are not operationally involved in day to day matters) can complicate relations and potentially dilute the effectiveness of the board as a vehicle for introducing operational improvements.

However for co-investors, “the purpose is that either good or bad, we know what’s going on. We are relying on the GP to manage the investment but as opposed to just sitting back and waiting for the result we require a highly transparent flow of information,” adds Evans.

All difficulties of co-investments aside, GPs who sympathise with that sentiment place themselves in a more favourable position with investors.