Co-investments, in which investors and a sponsor’s primary fund invest alongside each other in an M&A deal, have become a staple of today’s private equity landscape.
It’s not hard to see why.
Investors rely on co-investments to build out their PE exposure on a selective basis and to increase their net returns, since co-investors generally pay reduced or no management fees or carry.
Sponsors, in turn, use co-investments to attract investors to their funds, to build or grow relationships with prospective or existing limited partners, and to facilitate acquisitions that would otherwise violate a fund’s diversification limits.
Given the importance of having an effective co-investment strategy, and of avoiding potential pitfalls, my Torys LLP colleague Jamie Becker and I have come up with some “how-to” guidelines for investors negotiating and managing co-investment arrangements with PE sponsors.
Active or passive?
Generally, co-investments come in two varieties: active and passive.
In an active co-investment, investors and the sponsor’s primary fund will invest alongside each other in the target or top holding company. Active co-investments are most frequently used where co-investors are approached prior to the signing of an M&A deal, or where they are asked to commit a large portion of the equity cheque.
In a passive co-investment, investors typically invest through a special purpose vehicle controlled by the sponsor, often a limited partnership or an LLC. The vehicle pools the co-investors’ capital and is a party, along with the sponsor and management, to the main shareholders agreement. As such, passive co-investors often find themselves one level removed from the target company or the top holding company.
What to consider before co-investing
What should investors consider when negotiating a co-investment? Below we cover five key issues that are frequently encountered when negotiating passive co-investments, although some will also have applicability for active co-investments.
Passive co-investors are generally required to bear expenses relating to the formation and operation of the co-investment vehicle.
In part due to the SEC’s recent focus on disclosure, co-investment agreements often include a comprehensive list of the types of expenses to be borne by co-investors. Rather than haggling over individual items on the list, co-investors may wish to focus on negotiating caps on the amount of these expenses.
In addition, if the primary fund is investing through the co-investment vehicle, investors should request that the fund bear its pro rata share of expenses. Not only is this appropriate from a fairness perspective, it also strengthens the sponsor’s incentive to keep expenses low since higher expenses mean a lower return for the fund.
Passive co-investors also typically bear their pro rata share of deal expenses if the closing occurs. When passive co-investors are committing equity prior to the closing of the underlying M&A transaction, they are sometimes required to bear their pro rata share of broken-deal expenses; however, the practice is more varied on this point.
Funding of expenses varies among passive co-investments: Formation and transaction expenses are typically funded up-front, when co-investors fund their commitment. By contrast, operational expenses can be funded annually as incurred, withheld from distributions or funded up-front for the life of the co-investment.
If expenses are funded up-front, investors should ensure that the sponsor is obligated to return any unused portion at the end of the life of the co-investment. Logistically, it is important for co-investors to understand the amount of expenses and the funding mechanic early in the process so that they can secure approval from their investment committees for their expense commitment in addition to their capital commitment.
2. Alignment on liquidity
Co-investors generally want to be able to monetize an investment when the primary fund exits.
In active co-investments, alignment on liquidity is typically achieved via so-called tag-along and registration rights. In passive co-investments, since co-investors are not party to the main shareholders agreement, provisions regarding alignment on liquidity are often less detailed, and sometimes limited to general “tied-at-the-hip” clauses.
Not infrequently, the sponsor’s first draft of these clauses requires the co-investment vehicle to sell its interest in the target company at the same time and on the same terms as the sponsor’s primary fund.
Co-investors should make sure that these types of provisions are not styled as an obligation on the part of the co-investors but instead as a right that is enforceable against the sponsor. They also should resist qualifications that sales must only be “generally” or “substantially” at the same time and on the same terms as those by the fund.
For any type of co-investment, co-investors should strive for as much alignment with the primary fund as possible, including pro rata sharing of transaction costs and indemnification obligations for representations relating to the target company, and requiring that sales be on the same economic as well as non-economic terms.
Similarly, if the primary fund has a choice of consideration, then co-investors should get the same choice. Co-investors may also wish to resist non-competes, non-solicits or other restrictive covenants in connection with a sale.
Finally, co-investors should consider to what extent they want to preserve alignment on liquidity following an IPO. While this point is often addressed in active co-investments, it rarely receives the attention it deserves in the passive co-investment context.
Sponsors often seek to preserve the right to syndicate a portion of the primary fund’s interest in the target company after closing the M&A deal without the application of co-investors’ liquidity rights.
Syndication is a concern for co-investors because it has the potential to decreases the sponsor’s “skin in the game.” A lengthy syndication process also carries the potential to distract the sponsor from managing the investment.
Co-investors may accordingly seek to limit the period during which a post-closing syndication can take place (e.g., to three to six months). They may also wish to establish a minimum equity hold for the sponsor.
The co-investment documentation will typically allow the fund to transfer all or a portion of its interest in the target company to an “affiliate” without the application of the co-investors’ liquidity rights.
“Affiliate” is typically defined by reference to control, which means that the affiliate transfer right theoretically enables a sponsor to form another vehicle that it controls, admit additional co-investors into that vehicle and transfer a portion of the primary fund’s interest in the target company to the new vehicle. Whether intended or not, the affiliate transfer provisions thus create a potential syndication backdoor that co-investors should seek to close.
4. Structuring challenges for passive co-investments
Passive co-investments present a unique set of challenges because, as discussed, co-investors are at least one level removed from the information, governance and liquidity rights in the main shareholders agreement. However, many of the rights that passive co-investors have are a derivative of the rights contained in the shareholders agreement.
Accordingly, co-investors should review and be comfortable with the agreement. Co-investors should also ensure that their co-investment rights are properly overlaid on the rights in the shareholders agreement.
For example, the time periods and carve-outs from the pre-emptive rights in the co-investment documents should be consistent with those in the shareholders agreement. In addition, if the co-investment documents provide that the co-investment vehicle will sell its interest in the target company at the same time and on the same terms as the primary fund, the liquidity regime in the shareholders agreement must allow for this.
Co-investors should also seek contractual assurance that the shareholders agreement will not be amended in a way that negatively affects the rights that are passed through to co-investors without their consent.
Finally, co-investors should ask for the right to require the sponsor to enforce the co-investment vehicle’s contractual rights under the shareholders agreement.
5. Affiliate transactions
A selling feature of passive co-investments for co-investors is that they pay reduced or no management or carry fees.
But that is not to say that co-investors do not bear any fees.
The target company will often pay monitoring and transaction fees to the sponsor, a portion of which is indirectly borne by the co-investors through their interest in the target company. While those arrangements are typically disclosed to the co-investors at closing, absent contractual protection, nothing prevents a sponsor from amending monitoring agreements entered into at closing or layering on additional fee-bearing arrangements.
These types of fees are often offset, dollar-for-dollar, against the management fee paid to the sponsor by the primary fund. However, the benefit of the management fee offset extends only to a co-investor’s equity investment through the fund. Because there is typically no similar offset for co-investors in respect of the equity committed alongside the fund, any incremental target company fees have a direct impact on a co-investor’s return. Co-investors should therefore seek protection against the sponsor layering on these additional fee-bearing arrangements.
At a minimum, the sponsor should be required to disclose all fee-bearing arrangements to co-investors. This imposes discipline on sponsors as they know that all of these arrangements will be subject to co-investor scrutiny.
Alternatively, co-investors could request that any deal between the co-investment vehicle or the target company, on the one hand, and the sponsor or any of its affiliates, on the other hand, be approved by a majority of co-investors. This gives co-investors much greater fee protection but the sponsor will often oppose this as unduly limiting its flexibility to manage the investment.
A compromise approach is that all such transactions must be on arm’s-length terms, though before agreeing to this compromise, co-investors should be aware that it may be difficult in the PE context to demonstrate that a particular fee-bearing agreement does not reflect arm’s-length terms.
Another potential compromise is that the sponsor can enter into affiliate transactions if those are approved by the primary fund’s LP advisory committee.
While this provides co-investors with some protection, they should be wary about this approach. This is because the mix of investors in the fund may be different from the mix of co-investors and because the interests of the two groups may differ, including due to the absence of a management fee offset for the co-investors.
Stefan Stauder is a partner at Torys LLP with a broad transactional practice that includes M&A and private equity. He wrote this article in collaboration with Jamie Becker, a senior associate who practices corporate and securities law with a focus on M&A and capital markets transactions.
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Photos of Stefan Stauder and Jamie Becker courtesy of Torys LLP