Earlier this year at the US Securities and Exchange Commission’s national headquarters in Washington DC, Igor Rozenblit, considered the commission’s in-house guru on private equity, issued a plain but important warning on co-investment disclosures to a room full of private fund compliance professionals. “Make sure you have your bases covered,” he urged.
He went on to add a few specifics. If co-investments are allocated based on who re-ups in a successor fund, it should be communicated upfront to all LPs at once, not just to the ones targeted during initial marketing. Second, he said, disclosures need to happen soon enough so that LPs have a “chance to call and complain” about why they haven’t been offered a stake in the deal.
The fact that Rozenblit used part of his limited time at the conference to discuss co-investments suggests this is a particular area of focus for inspectors, as they wrap up their two-year sweep of newly-registered private fund advisers. And if there was any doubt about this, Rozenblit again reminded the industry that co-investment disclosure was high on the commission’s priority list during a webinar hosted by the Association for Corporate Growth in May.
No wonder, then, that in the subsequent months, private fund advisers – and more specifically their compliance teams – have been making major changes to the way they disclose and share deal opportunities with their limited partners.
Part of the SEC’s thinking is that co-investments are being used as marketing tools – so some investor protection is needed to ensure that promises made during fundraising are being fulfilled. Inspectors apparently want to see that every prospective LP is given a heads-up that co-investments are part of the GP’s repertoire – and, ultimately, is given the chance to take part in these deals.
“[Disclosure] doesn’t have to be before the co-investment happens or immediately after, but in some reasonable time period that would enable investors who think they ought to be getting co-investments to call their manager and advocate themselves,” Rozenblit said during the webinar, where he was speaking alongside his colleague Marc Wyatt. The two men will co-lead a recently assembled SEC inspections unit dedicated to private funds.
It’s worth stressing that the SEC doesn’t think every LP should necessarily be offered the chance to co-invest; that’s a decision that rests with the GP. But according to Rozenblit: “All investors should be aware of the criteria of co-investment allocation before committing their cash.”
The SEC’s focus on co-investments was a popular talking point at PEI’s Private Fund Compliance Forum in New York this year. Delegates at the conference said co-investment policies were receiving plenty of scrutiny during presence exams.
One industry CCO in attendance mentioned that her firm now documents why certain LPs are offered co-investment opportunities ahead of others, in order to meet SEC expectations. “We can point to side-letters that show certain LPs are only interested in certain industries, or that some LPs can only come on board if they have enough of a time window.”
A second CCO in attendance added that these documents also help the deal team remember why certain LPs were selected over others during a co-investment opportunity. “It can be hard to recreate the facts during a stressful presence exam.”
Be specific, but not too specific
At the very least, most GPs are updating their marketing materials and Form ADVs (which SEC-registered advisers are required to file for regulatory purposes) to provide more description of their co-investment policies and procedures.
What’s also popping up in PPMs and regulatory filings is more detailed explanation around how co-investments are allocated to employees and affiliates of the firm, or other third-parties, says Gary Watkins, who as a consultant with ACA Compliance Group has helped many GPs through SEC inspections. Inspectors want to see how co-investments pay for a portion of expenses resulting from new deals too, he adds. “Where appropriate, they want to make sure the primary funds aren’t picking up the entire costs associated with a deal that involved a co-investment vehicle.”
But there’s a flipside to all this extra disclosure, compliance experts warn. On the one hand, GPs are doing what they can to feel safe in the knowledge that investors have been sufficiently debriefed on their co-investment policies and procedures. On the other hand, with every additional sentence written, they’re opening themselves up to additional SEC scrutiny.
“When you look at co-investment disclosures, it’s this odd result of being both very specific and very vague at the same time,” says O’Melveny & Myers investment funds partner Tim Clark.
For example: legal advisers are drafting disclosures stating that the co-investment vehicle may charge fees, but not stating explicitly what types of fees can be charged (i.e., management fees, transaction fees, etc.). Likewise for which types of vehicles can be used for co-investments (i.e., partnerships, corporate vehicles or separately managed accounts) and which of the manager’s funds even have co-investment vehicles.
A similar strategy is being used to manage timeline expectations around co-investment deals. As mentioned, SEC inspectors are worried that marketing materials are giving all LPs, both large and small, the impression that co-investments will be available for everyone post-commitment. But a disclosure stating that co-investment deals will be made under a tight timeframe (or words to that effect), without offering any specific deadlines, is a way to manage the expectations of smaller LPs, who tend to need longer to make a co-investment decision.
In some areas though, vague disclosures may meet with some push-back from the SEC, cautions Debevoise & Plimpton investment funds partner Ken Berman. He specifically mentions situations where a co-investor other than the fund’s LPs joins the deal.
“A big area of disclosure relates to in what circumstances the GP can bring on outside parties to the deal – for example a financial institution [to provide] a debt package to the deal, or another GP to form a consortium. The SEC wants to know how you handle any potential conflicts of interest here.”
What remains to be seen in the coming months, then, is how GPs will balance the need to offer sufficient co-investment disclosure with the danger of exposing themselves to unnecessary compliance risk. For now, the fear is that because there has been no enforcement action yet, best practices still aren’t sufficiently developed.