Singled out

The last 24 months have seen a marked increase in the number of co-investment arrangements that use broader private equity fund characteristics (such as management fee and carried interest structures) but involve just a single underlying asset.

Chris Gardner

For both spin out teams and other newly established sponsors, such structures provide a means to establishing a track record for their investment management and advisory businesses on the back of individual assets before embarking on a wider fundraise.  For more established sponsors, they provide a way of harnessing capital which, for whatever reason, is reluctant to commit to blind pool investment.

These structures, like private equity funds, are essentially quite sophisticated joint venture-type co-investment arrangements.  They can be documented through either a shareholder agreement or limited partnership agreement, depending on the vehicle used for the chosen structure.  Such structures can be established in offshore fund jurisdictions such as the Channel Islands; alternatively, they can be established directly in a double tax treaty jurisdiction such as Luxembourg (effectively making the co-investment structure and the acquisition vehicle one and the same).

Some of the key benefits when compared to “fuller” fund structures include:

– offering investors an identified asset in which to invest, thereby avoiding ‘scope creep’ or other investor concerns around how a blind pool will be deployed;
– a clearer and shorter path for sponsors to obtaining investor commitments;
– an ability opportunistically to acquire individual assets on an accelerated timetable;
– a more streamlined (and cheaper) structure than would be the case for a full fund; and
– an ability to give key management and other stakeholders a direct interest in the acquisition vehicle.

Gus Black

Many sponsors will, of course, have in their mind both an exit strategy for the asset and a long-term relationship with investors.  Frequently, the ultimate goal will be to have investors reinvest into a fuller fund structure, whether that is once the fundraising climate has become more friendly, or a track record through successful management of the asset has been established.  Indeed, if investors agree, the asset could in due course be contributed to a fuller fund structure as a seed asset.

Sponsors should consider dealing with this exit strategy and the long-term relationship at the outset.  Some of the key issues to be addressed will include:

– how any re-investment into the follow-on fund is to be structured so that it is tax-efficient for investors (who may not want to have to realise a capital gain if they are effectively recommitting and have a dry tax charge to settle); and
– if the single asset is to form a seed asset for the fund, the basis on which it is to be valued when it is transferred into the fund.  Existing investors will want to ensure that incoming investors do not get a ‘free ride’ and incoming investors will not want the asset to have a value attributed to it that is above its fair market value.  Sponsors will also not want to get into a situation where they find themselves with a conflict of interests arising out of this valuation, and may wish to have a fairness opinion or third party valuation commissioned.

Whilst establishing a single asset structure is less costly and time intensive than a full fund structure, there are still a number of issues that need to be considered.  These include agreeing with target investors a holding structure that works from a tax and regulatory perspective for all investors, and coming to commercial terms including fee arrangements and investor rights.  If a sponsor is likely to be able to identify a series of separate assets, then cost advantages may diminish as a new structure and documents will likely be required for each repeat asset.

The signs are that the fundraising climate does appear to be getting more sponsor-friendly, but there is likely to be continuing need in the short and medium term for single asset structures.  Such structures fill a funding gap by providing an expedited route to capital sources for completing M&A deals that in turn may form the foundation for coming years’ private equity fund vintages.