Sponsors and their limited partners aren’t sure what to make of the U.S. Securities and Exchange Commission’s plans, if any, on regulating co-investments.
The SEC, which has been gathering information about how co-investments work, could of course do nothing. It could require sponsors to disclose more information to investors about their co-investment policies. Or, while seen as unlikely, the agency could require sponsors to handle co-investments in a particular way, such as by notifying all investors of an opportunity in advance and giving them an equal chance at buying in.
During a public meeting in January, Igor Rozenblit, specialist with the SEC Division of Enforcement in the Asset Management Unit, said he believes general partners should let LPs know on what basis they are going to offer opportunities for LPs to co-invest in deals alongside sponsors,. He also said GPs should disclose to all LPs when a co-investment is going to happen.
“Let them know in a timely enough way so if someone didn’t get a co-investment opportunity, it gives them a chance to call and complain” and try to convince the GP to allocate them a piece of the co-investment, Rozenblit said. The SEC declined to comment further on the subject for this article.
Generally, GPs pick and choose which LPs to co-invest with—the ones that they know to be reliable and that can make a decision quickly on whether or not to join a deal. Some GPs survey LPs to find out which ones want co-investment. It would be unusual for a GP to offer every LP in a fund the opportunity to co-invest, sources said.
One source with knowledge of the SEC’s thinking said: “Chances are, they need more information to decide what the policy will be. That bodes well, in my opinion…That means they’re not regulating first and figuring it out later.”
It is unlikely, sources said, that the SEC would come up with a hard-line rule governing co-investing. The SEC would likely be satisfied if GPs were transparent about co-investing, such as by disclosing how the fund determines who to participate, and how opportunities are allocated between the fund and co-investors, said Kerry Burke, a partner in the corporate and securities practice at law firm Covington & Burling LLP.
“This has become more of a focus as more people start to think through these issues,” Burke said, adding she doesn’t think rules restricting co-investments are imminent. “I don’t see how you would do that effectively.”
Co-investing appears to becoming more popular as limited partners look for a way to reduce fees and gain more exposure to the deals of favorite sponsors. Coller Capital’s Winter 2013-2014 Global Private Equity Barometer, which surveyed 113 private equity investors from around the world, found that more than half had co-invested with their GPs in the last two years. Also, the “typical” LP invests 10 percent of its total private equity commitment directly into private companies (either solo or in co-investments).
Within the next three to five years, that number is expected to jump to 15 percent, according to Coller Capital’s survey.
While affording opportunities for strong returns, co-investments do come with risks.
A recent draft academic paper by three professors, including two from Harvard Business School, found that co-investments underperformed fund investments over the 20 year study period. The “poor performance appears to result from fund managers’ selective offering of deals at market peaks,” the authors wrote. The paper was co-authored by Lily Fang, associate professor of finance at INSEAD; Victoria Ivashina, associate professor of finance at Harvard Business School; and Josh Lerner, professor of investment banking at Harvard Business School.
It will be interesting to see if the SEC eventually comes out with guidance on co-investments, but from what peHUB has heard, the industry—both GPs and LPs—would really prefer if the agency backed off this issue.
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