In this Ropes & Gray podcast, asset management partners Isabel Dische and Adam Dobson discuss points that investors should consider when negotiating terms of co-investments in light of the dramatic growth in the fund recapitalization market.
Isabel Dische: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on topics of interest for asset managers and institutional investors. I’m Isabel Dische, a partner in our asset management group based in New York and co-head of our institutional investor practice. I’m joined today by my Boston-based asset management partner, Adam Dobson. As you’re well aware, fund recapitalizations have boomed in recent years and are now a common portfolio management tool for fund sponsors. These transactions have implications for co-investors who are invested in one or more of the assets at the center of a fund recap. Today, we are going to be talking about some points investors may want to keep in mind as they negotiate the terms of co-investments given the dramatic growth in the fund recapitalization market.
Adam Dobson: While sponsors have pursued fund recapitalizations for years, it is only in the past few years that they have become a widely accepted portfolio management tool and as we’ve noted in prior podcasts, we are now seeing sponsors engage in fund recapitalizations not only as a tail-end solution, but also as a mechanism for crystalizing returns on a successful asset.
So what does that mean for your typical co-investor? First, remember that co-invests are set up as a construct for co-investors to invest alongside a sponsor, mirroring their economics over the life of the deal, a concept we colloquially refer to as “handholding.” So, among other things, a co-investor will want to have the right to sell alongside the lead sponsor, at the same price and on the same terms, when the lead sponsor sells.
A key question, however, is what does it mean for the lead sponsor to sell and, in particular, do the co-investors’ tag rights apply to sales by the lead sponsor’s current fund to another fund managed by the same sponsor, as is the case with a continuation fund in a fund recapitalization?
Isabel Dische: Many co-invest agreements include a concept of permitted transfers—that is, a subset of transfers to which the tag rights do not apply—and it is fairly common for the permitted transferees of a fund to include other investment vehicles managed by the same sponsor. Historically, because recapitalizations were relatively uncommon, co-investors viewed this affiliate transfer rights as a reasonable accommodation to permit portfolio management by the sponsor. In the fund recap context, however, what this means is that co-investors would not be able to tag to the sale by the sponsor’s original investing fund to the continuation fund. How a co-investor views this will depend on a number of factors: For example, how concerned is the co-investor that the price at which the recap is being consummated is “fair”? Historically, concerns around pricing have led many investors to conclude that they’d rather stay in the deal alongside the successor fund rather than risk tagging at too low a price in a transaction where there isn’t an objective third party price. Related, a co-investor may simply want to mirror the decision the lead sponsor is taking with respect to its own capital—in most fund recapitalizations, the lead sponsor rolls its carry and/or makes a meaningful investment in the continuation fund—and if the lead sponsor is going to remain invested, a co-investor may want to do the same rather than be cashed out in the transaction.
There are also other factors that may persuade a co-investor to prefer to have the option of tagging in a fund recap. For example, a co-investor might want to crystalize gains from the co-investment, in particular, if it is less bearish on the investment than the sponsor (or if the co-investor simply has a need for liquidity). A co-investor also might feel differently about the pricing risk if they know that the sponsor is cashing out a material portion of carry in connection with the recap. Further, the fund recap will by its nature extend the anticipated hold period of the investment, typically by several years, and a co-investor might not want to extend the investment horizon, which is a risk since many co-investment terms are tied to the disposition of the assets.
Adam Dobson: Another factor at the front of mind for many co-investors is the risk of getting burned. Even where not contractually obliged to do so, we have seen sponsors allow co-investors to tag in connection with a fund recapitalization. Over the past year, however, there have been several such transactions where intervening market events, such as the choppy markets we saw at the outset of the COVID-19 pandemic, have meant that sponsors were not able to provide that liquidity on the same price and terms for co-investors or where sponsors were unwilling to provide any liquidity at all. Needless to say, that isn’t a popular outcome from the perspective of a co-investor (and it also isn’t ideal from a fund sponsor’s perspective as an investor relations matter).
For all these reasons, we have started seeing co-investors rethink how transfers to affiliated funds should be treated under the co-invest documentation. Some co-investors are questioning whether these transactions should be permitted transfers to which tag and comparable rights do not apply and are instead seeking optionality in the recap context—for example, seeking contractual comfort that the co-investor will be able to elect whether to sell or continue its investment in the event that the main fund undergoes a fund recapitalization involving the underlying portfolio company. Other co-investors are instead pressing to make clear that these transactions would be deemed to be permitted transfers so they can avoid being cashed out.
Another tension for the sponsors in this context arises from the fact that the terms of a fund recapitalization are typically negotiated with third party lead investors who will have their own view as to the desirability of including co-investors in a recapitalization transaction. If there is insufficient demand from new investors, the sponsor will have to determine whether it’s advisable (or permissible) to cut back co-investors and fund investors on a pro rata basis or to cut back co-investors first. On the other hand, the addition of co-investor equity may give new investors additional exposure to attractive assets. The desirability of including co-investor equity in a recapitalization transaction will vary from deal-to-deal, which is why co-investors will want to focus on this issue at the time of the initial co-investment when they have the maximum leverage to negotiate their desired outcome.
Isabel Dische: Needless to say, there’s a lot to consider. Thank you, Adam, for joining me today for this discussion. And thank you to our listeners. For more information on the topics that we discussed or other topics of interest to the asset management industry, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we discussed—please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
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