Please everyone, please no one

The co-investment offering process used to be relatively simple. GPs had relationships with certain LPs; knew who might be willing and able to kick in more capital to double down on deals; and asked those investors at their discretion when the right opportunities arose. But the strategy’s popularity has put these offering practices in the spotlight, leaving both regulators and LPs asking for more from GPs.

 

Back in 2012, the US Securities and Exchange Commission (SEC) first made it known that it would be looking out for conflicts of interest arising in private equity co-investments. Speaking at the PEI Private Funds Compliance (PFC) Forum 2015 last month, newly appointed SEC chief inspector Marc Wyatt reminded the audience of private equity compliance professionals that co-investment scrutiny has not diminished. Rather, the regulator is focusing even more intently on the offering process during exams, aiming to ensure that the opportunities are represented clearly and fairly to all LPs.

 

GPs, attempting to reconcile their growing use of co-investments with the increase in regulatory oversight, are grappling with another challenge: an appetite for co-investment opportunities from LPs who don’t actually have the resources to participate.

 

Now, more than ever, the competing interests of GPs, LPs and regulators are colliding when it comes to deciding who gets to participate in co-investments and how much is disclosed.

 

 

The exam team at the SEC, with their limited (if growing) experience in the private equity industry, may be having difficulties when assessing the co-investment offering process because of how much the practice varies from firm to firm. Without an industry standard subscribed to by all, examiners looking at a co-investment policy may be stumped to determine whether a manager is breaking their fiduciary duty or not.

 

“It’s all over the place,” says one private funds lawyer on the matter. “Every manager is different.”

 

The most significant variance? Whether the co-investment rights are distributed in a discretionary or formulaic fashion. For most GPs, the discretionary route – offering co-investment opportunities to whomever, whenever – has been the norm. But now more investors want access to every potential co-investment, and are asking for a more structured approach.

 

For some GPs, this means offering all LPs the opportunity to invest in each co-investment deal as the opportunities arise. For others, this means offering these opportunities, but letting LPs know that the option to invest is on a “first come, first served” basis. Some firms determine an investor’s stake in the co-investment using a formula, allotting a proportional co-investment amount to an LP based on its commitment to the main fund, notes Oliver Schumann, managing director at global asset manager Capital Dynamics.

 

As an example of the variety and evolution in co-investments: a head investment professional at a large US retirement system tells pfm that, when her pension first began its co-investment program a few years ago, it would fight to get co-investment rights into the Limited Partnership Agreement (LPA).

 

“We were fine with everyone having that right, or at least investors as big as or bigger than us having that right,” she comments.

 

Over time, however, the pension’s co-investment program has become more sophisticated, and the LP trusts its managers to stick to promises for co-investment rights without any contractual agreements. “Now we focus less on getting it into the contract but instead making sure we maintain that relationship with the GP.”

 

She admits that now she doesn’t always know who her GP is offering the co-investment rights to, but does not mind as long as her pension is getting in on the deals.

 

Many large LPs share her sentiment, leaving the offering process to the GP’s discretion. This may involve some level of structure with provisions like “early bird investor privileges” in which those LPs in the first close may have preferential access to co-investment rights, but again, this varies manager to manager.

 

“They go to those they think are likely to close and who are able to take down as much of the potential capital as possible,” adds one private equity consultant whose clients include some of the largest public pension plans in the US.

 

From a regulatory perspective, that could be a problem. The SEC wants written policies and procedures on co-investments (even if they are discretionary) in LPAs, private placement memoranda (PPMs), and Forms ADV Part 2A. And once smaller investors invoke a “Most Favored Nations” (MFN) clause, those disclosed discretionary practices automatically become formulaic.

 

Wyatt mentioned this need for written policies in his speech at the PFC forum, but noted that, instead of being more transparent, some GPs have answered the SEC’s call for more disclosure by clamming up on co-invests.

 

“Many have responded to our focus by disclosing less about co-investment allocation rather than more under the theory that if an adviser does not promise their investors anything, that adviser cannot be held to account,” he said. “However, the risk in that approach is that such promises are often made anyway, either orally or through email.”

 

The Office of Compliance and Inspections and Examinations (OCIE) has “detected several instances where investors in a fund were not aware that another investor negotiated priority co-investment rights,” Wyatt noted.

 

“To be clear, I am not saying that an adviser must allocate its co-investments pro-rata or in any other particular manner, but I am suggesting that all investors deserve to know where they stand in the co-investment priority stack,” he said.

 

Unfortunately for many GPs, this suggestion does not align with their current processes. While comforting that the SEC is not advocating a pro-rata offering process, as some LPs have called for in the past, many GPs don’t inform LPs who are not offered co-investments that their peers are getting in on the deals, one lawyer noted in talks with pfm.

 

It’s not only US-based GPs who are dealing with increased restrictions on co-investment processes, however. Although managers are not facing the same pressure for fair policies, the marketing restrictions in the Alternative Investment Fund Managers Directive (AIFMD) have made the traditional route of reaching out informally to prospective LPs regarding co-investment opportunities less straightforward. In response, some non-AIFMD-authorized GPs are looking to reverse solicitation, relying on LPs to take the initiative regarding co-investments.

 

“Some fund managers now don’t want to offer co-investments from their side for regulatory reasons, unless the LPs go to them in writing and express formally that they have an interest,” notes Schumann.

 

 

While the industry and regulators are clashing with one another on questions of discretion and disclosure, LPs are sparring with GPs and with one another in their attempts to jump on the co-investment bandwagon.

 

“The offering process has turned 180 degrees and become the demanding process,” says David Smith, also a managing director at Capital Dynamics, indicating the role reversal that has taken place as the popularity of co-investments has soared in the past few years.

 

Between Q3 2011 and Q2 2014, funding for co-investment vehicles has compounded seven-fold, according to data from PEI’s Research and Analytics team.

 

But more LPs clamoring for co-investments is not necessarily a positive trend. Smaller LPs are requesting co-investment rights or invoking them through an MFN clause even if they don’t necessarily have the ability to execute the deals on time, says the private funds lawyer.

 

Once a GP notifies an LP about a co-investment opportunity, the investor ideally has about four to eight weeks to conduct its own due diligence and decide if it will go in on the deal, the consultant notes. However, the timeframe can be squeezed to as little as 10 days, becoming a “fire drill” to properly assess the portfolio company, he says. Although smaller LPs may have fought for this kind of insider access, they often do not have the staff to handle it, and end up opting out.

 

“We have been involved in deals where the GP has spoken to a handful of investors and the ones who are interested all make it by the deadline and everyone is very professional,” says Schumann.  “And then we have GPs who have said, ‘I had 50 emails expressing interest and only two co-investors were there at the end, and I struggled to find those two.’”

 

Aside from the inability to turn due diligence around quickly, smaller LPs may also find putting capital into a co-investment puts them at risk of having too much exposure to in single portfolio company, the consultant notes, stating he does not encourage co-investing for most his clients.

 

“It’s not for everyone,” says the consultant. “People see what CalPERS does but they can’t do it.”

 

The public pension plan LP, who used to ask for co-investment rights in every contract, now prefers when GPs don’t include it, because other investors will get access to them and “slow down the process.” She notes that while smaller investors tend to get into co-investments with the aim of reducing their overall fee payments to a GP, larger LPs use the opportunities to build a stronger relationship with the manager.

 

“It gives you a good perspective on the manager’s investment process and style that you don’t necessarily get when you’re just in the fund,” she says. “When we ask for co-investment rights, we’re not asking for the optionality, we’re asking for it because we plan to use it.”