By Lisa Peterson, Akin Gump
Fund sponsors see co-investment opportunities as a way to mitigate fundraising challenges, recruit strategic partners and develop strong relationships.
Some sophisticated fund investors, including institutions, family offices and high-net-worth individuals, leverage co-investments to increase exposure to high-quality managers, with an improved risk/return profile and more diversification, at a lower cost.
Some even make co-investment rights a condition of a primary fund commitment. Would-be investors should, however, be aware of pitfalls that can lurk in co-investments.
Overview: A co-investment is a minority investment in an operating company alongside a private equity fund or other financial sponsor. Economic terms and structure must be solidified at the outset. The co-investor’s goal should be alignment of interests with the sponsor. There are two typical basic co-investment structure alternatives, each with its own considerations:
Direct Investments: Here, a co-investor has a direct ownership interest in a portfolio company alongside the sponsor’s primary fund. The co-investor will have direct contact with the company, will not have its investment controlled by the sponsor and can directly exercise rights as an equity holder of the company.
Investors preferring direct co-investments typically have the infrastructure and experience to analyze and manage individual portfolio positions. The direct co-investor will need to be actively involved and the documents relating to the company will need to be tailored to address the needs and rights of co-investors, some of which are discussed below.
Tag-Along/Drag-Along Rights. A tag-along right gives the co-investor the right to sell its interest at the same time and on the same terms as the sponsor. Without this protection, a co-investor could be left holding its interest in the operating company long after the sponsor has exited.
The sponsor will often require the co-investor give the sponsor drag-along rights (so a purchaser can be assured of its ability to acquire 100% of the company).
In both tag-alongs and drag-alongs, the co-investor will want the representations and warranties it is potentially required to give to be appropriately limited (i.e., to its ownership and not to the company’s operations or financial performance) and its potential liability under any future sale agreement to be limited (never to exceed the sale proceeds actually received).
Preemptive/Other Purchase Rights. A co-investor should also have the right to retain its percentage ownership interest in the portfolio company. Without this protection, the co-investor’s interest could be diluted by future equity issuances. Co-investors may also want right of first refusal on sales by other equity holders, especially if the sponsor will have that right.
Information Rights. With a direct investment, the co-investor is charged with its own investment oversight, making it critical that it be provided with sufficient company information on a routine basis. The desired amount of information and the operative time periods (e.g., monthly, quarterly or annually) vary among co-investors.
Veto Rights. While the sponsor should have general management rights, certain actions should require the approval of the co-investor (or, in some cases, a majority in interest of co-investors). Actions to consider include amendments that would affect the essential economic agreement, affiliate transactions, changes to the company’s basic purpose/line of business and other fundamental changes.
Other Rights/Documentation. Other provisions that should be considered are appropriate expense provisions, rights to remove the general partner (often mirroring the main fund agreement), rights to access company management and, sometimes, registration rights. In a direct investment, there will be significant overlap with management interests, so putting together legal documents may not be straightforward (a single document will likely address the arrangements of both co-investors and management). Additionally, planning for an eventual exit transaction can be more complicated under this scheme.
Investment Through Sponsor-Controlled Vehicles: Here, the co-investment is made through a sponsor-formed special purpose vehicle and the sponsor controls the investment, much as it would a primary fund investment. The co-investor must preserve its rights to the same degree they would be in place in a direct arrangement (i.e., all rights at the company level must flow through the SPV to the co-investors). Unfortunately, co-investors are often presented with an SPV agreement that looks very similar to the main fund agreement, which doesn’t make sense due to the many additional provisions that need to be included.
Legal Fees/Timing: The expenses associated with legal work for either alternative are likely to be significantly greater than with an ordinary fund investment because the co-investment structure can be complex. These fees are typically more than offset by the no-fee, no-carry basis of the co-investment. Also not to be overlooked is the somewhat longer time frame generally associated with a co-investment.
Involvement in Underlying Transaction: Another critical decision involves how much a co-investor is involved in the underlying transaction. Some co-investors are actively involved, while others rely totally on the sponsor. Most take a middle-ground approach that entails speaking with the sponsor’s counsel about its diligence approach and key underlying deal documents, reviewing its formal due diligence report, and following up with any concerns.
Summary: No matter the structure or level of diligence, it is critical that the interests of the co-investor and the sponsor are aligned. For the co-investor to get the benefit of the deal it has struck, care must be taken from the start.
Lisa A. Peterson is a partner in the corporate practice in the Dallas and Fort Worth, Texas, offices of Akin Gump. She works with private investors, including family offices, in the full range of their fundraising and investment activities. She also works with clients investing in traditional asset classes. Reach her at +1 817-886-5070 or firstname.lastname@example.org.