In this Ropes & Gray podcast, asset management attorneys Isabel Dische, Adam Dobson, Jessica Marlin and Alex Chauvin discuss some of the issues sponsors, investors and secondary buyers will want to have in mind as they navigate the intersection of co-investment transactions and GP-led fund recapitalizations. They discuss some considerations for sponsors and investors at the time of the initial co-investment, preparing for the possibility of a future GP-led fund recapitalization, as well as considerations for secondary buyers contemplating a potential GP-led fund recapitalization involving co-investment positions.
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. Joining me today are my Boston-, New York- and London-based asset management colleagues, Adam Dobson, Jessica Marlin and Alex Chauvin. Today, we are going to be talking about the intersection of co-investments and fund recapitalization transactions from the perspectives of co-investors, fund sponsors and secondary buyers.
Adam, do you want to kick off our discussion?
Adam Dobson: Gladly. As we suspect most of our audience is aware, sponsors have for years offered co-investment opportunities for favored investors in a fund to co-invest alongside the fund in a deal. Co-investments allow fund investors to deploy more capital with a sponsor they like on a no fee, no carry basis. Not only do they have an IR benefit for fund sponsors, but co-investments can also help a fund sponsor raise purely passive capital for a deal above the fund’s targeted hold. Under your typical co-invest construct, the co-investors are largely passive, “holding hands” so to speak with the lead sponsor through life of the deal.
Tensions arise when co-investors are not aligned with the sponsor they are following, however, and one such instance is in a potential fund recapitalization transaction where a sponsor is selling from one fund to another. In particular, what should happen to co-invest stakes in such a transaction? Should they automatically sell alongside the main fund, or rather, should the only changes to a co-investor’s position be that following a recap they’ll follow the continuation fund rather than the original fund and can expect a longer-investment horizon?
Jessica Marlin: These are great questions, Adam, but these aren’t questions to which there’s a single answer. A typical co-investment agreement provides that co-investors will sell, or at least have the right to sell, if the lead sponsor is selling. Many agreements also provide a limited exception to the tag right for permitted transfers, however. If the governing agreements contain such an exception for affiliated transfers, then a co-investor’s tag rights may not apply to the fund recap, meaning that while investors in the main fund may have the option of selling into the recap, co-investors may not have the same optionality. Instead, those co-investors would remain invested in the company and their so-called “handholding” rights—their rights to purchase and sell alongside the lead sponsor—would thereafter instead look to the continuation fund.
By contrast, if the sale from the original fund to the continuation fund is not a permitted transfer, the co-investors’ tag rights would apply and the co-investors would have the right to tag to the sale (or in some cases, the co-invest agreements provide for automatic tags). Isabel, do you want to talk about those?
Isabel Dische: From the perspectives of institutional investors, fund sponsors and even secondary buyers, what the preferred outcome with respect to co-invest positions in a fund recap will be, will vary from deal to deal. For example, an institutional investor may worry that the price at which the recap is being effectuated is likely to be depressed, in particular, if the sponsor is more likely to earn carry under the continuation fund’s waterfall. Conversely, an institutional investor may worry about the extended time horizon of the investment or may simply want the cash. An investor also may worry that its relationship with the sponsor won’t be as strong at the time of the fund recap or even later.
From an investor’s perspective, maintaining flexibility to either sell or roll on a no fee, no carry basis is ideal, but many co-invest agreements set a default mechanic rather than allowing full optionality. As for which default is preferable, we’ve seen different investment teams within the same client hold opposing views—even over the course of the same week—with one team wanting the default to be that their co-invest positions automatically tag (and sell) in a recap, and another team wanting the default to be that their co-invest positions remain invested on a no fee, no carry basis with the only change being that post-recap, the handholding provisions would look to the continuation fund rather than to the original fund.
Alex Chauvin: Much as fund investors can articulate arguments in favor of both paths, fund sponsors and secondary buyers can do the same. If the co-invest agreements provide that co-investors have the option of tagging in the recap (or sell automatically), it will mean that the potential deal size is larger. That can be both good and bad. A larger deal opens capacity for more secondary buyers to participate, but it can also make it more challenging to raise continuation fund commitments. We have seen deals where sponsors have not been able to raise sufficient secondary capital to offer liquidity to all co-investors and have had to rely on the fact that they were not obliged to offer a tag right to those co-investors. (Even if the documents don’t expressly provide for a tag right, co-investors have at times still been disgruntled to be left behind.)
If co-investors have an option to tag, that also introduces uncertainty as to the asset mix that will be sold into the continuation fund, which may make the deal more or less attractive to a secondary buyer that is particularly focused on particular assets underlying the deal. The potential of increased concentration in an asset may make the deal more or less desirable. Depending on the terms of the co-invest securities, secondary buyers may find them less attractive. For example, co-invest vehicles may not be set up to provide more fulsome indemnity protections and it can at times be challenging to have rep and warranty insurance cover the co-investor sales.
Isabel Dische: Needless to say, there’s not a single “best” answer for how co-invest stakes should be treated in a fund recap and it behooves fund sponsors and investors alike to think through how they might want to approach a hypothetical recap at the time of the initial co-investment. By the same token, secondary buyers will want to give heed to how the participation of co-investors in a proposed recap could influence the transaction. There’s a lot to consider for fund sponsors, fund investors and secondary buyers alike.
Thank you, Adam, Jess and Alex, for joining me today for this discussion, and thank you to our listeners. For more information on the topics that we have 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’ve 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 Appleand Spotify. Thanks again for listening.
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