Welcome to Fully Invested, a podcast series from Ropes & Gray’s global asset management practice that provides insight into essential considerations associated with current and emerging asset management topics. Given the still-growing popularity of co-investments—both from the perspective of fund sponsors and fund investors—Isabel Dische, Adam Dobson, Nicole Krea and Jessica Marlin provide an overview in this episode of the basic structures used for co-investment transactions, as well as related issues that commonly arise in these deals. They also briefly touch on how the SEC’s proposed private funds rules from earlier this year may shift the co-invest paradigm.
Isabel Dische: Hello, and thank you for joining us today on this Ropes & Gray Fully Invested podcast, the latest in our series of podcasts and webinars focused on topics of interest for asset managers and 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- and New York-based asset management colleagues Adam Dobson, Jessica Marlin and Nicole Krea. Co-investments have exploded in popularity in recent years, and the four of us have been spending a significant portion of our time advising sponsors and investors on co-investment transactions—both helping paper individual transactions and advising on related regulatory and other issues. Given the continued growth in the popularity of co-invests—both from the perspective of fund sponsors and fund investors—in today’s podcast we wanted to take a step back to introduce our listeners to some of the basic structures, as well as related issues that commonly arise in these deals. We’ll also touch briefly on how the SEC’s proposed private funds rules from earlier this year may shift the co-invest paradigm.
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 can be used across asset classes, as well as for both private and public positions. A co-investment can be deal-specific—with the investor deciding to commit co-invest capital to a particular deal, or some sponsors will set up so-called “overage funds” that are designed to invest opportunistically whenever a sponsor’s main fund has achieved its targeted allocation to a particular deal. Some sponsors even will use both overage funds and deal-specific co-investments in the same deal. It is increasingly common for sponsors to use co-invest capital in their deals (and for some sponsors, it’s actually more common for them to use co-invest capital than invest solely through their flagship).
Co-investments allow fund investors to deploy more capital with a sponsor they like on a no-fee, no-carry basis, which effectively can reduce the overall fee burden on the capital that the investor has deployed with the sponsor. They also can be a way for a fund investor to increase its exposure to a desirable asset class or even a particular asset. For example, if an investor has particular conviction in a sponsor’s technology team, it might try to co-invest solely in technology-related co-investment opportunities that are presented to it, as a way to shift its overall exposure with the sponsor.
Setting aside the economic benefit to fund investors, co-investments offer advantages to fund sponsors, as well. Notably, they have a not insignificant investor relations benefit; by offering no-fee, no-carry co-investment opportunities to large investors in its funds, a sponsor may be able to strengthen its relationship with the large LPs, or it may use it to attract new LPs.
Co-investments also help a fund sponsor raise purely passive capital for a deal above the fund’s targeted hold, enabling it to stretch for an attractive opportunity.
Isabel, do you want to discuss some of the typical co-investment terms that parties discuss?
Isabel Dische: Sure. Under your typical co-invest construct, the co-investors are largely passive—I often describe it as “holding hands” with the lead sponsor through the life of the deal. There are lots of details to be negotiated in the context of a live deal, but the basic idea is that a co-investor’s return profile should match up with that for the main fund’s investment in the target.
A co-investor wants to have comfort that it is buying the same securities, in the same proportions, and at the same price and terms as the lead sponsor. If the sponsor is acquiring additional debt or equity securities of the target, the co-invest vehicle should at a minimum have the right to participate proportionally (and some deals provide for dry powder, so co-investors participate automatically in any follow-ons).
Likewise, the co-invest vehicle should have the right tag to participate proportionally and on the same price and terms in any exits. Because these are purely passive investments, co-investors also will seek comfort that they won’t be bound by any restrictive covenants or asked to make any representations or warranties that are outside of their control in connection with an exit.
Co-invest stakes are passive investments with control rights generally residing with the lead sponsor other than in limited instances, such as related party transactions where co-investors may not be perfectly aligned with the main fund. For example, a main fund LP might not object if a sponsor were to propose to take a new monitoring fee from the target because the main fund LP benefits from a management fee offset. As your typical co-invest is on a no-fee, no-carry basis, a co-invest position is not so protected, however, and co-investors typically want independent oversight over such fees. Fund recapitalizations are another common example of a type of related party transaction where co-investors’ interests may not align with those of main fund LPs. (Note that we recently released a podcast focused solely on the interplay of co-invests and fund recaps, and a replay of that podcast is available on our website.)
These are but a few of the issues that co-investors typically focus on. Other core concepts include expenses—in particular, whether or not co-investors are bearing dead deal exposure and confirming that a co-investor does not have uncapped liability to a deal—and reporting, among others.
Jess, do you want to discuss how sponsors typically address these concerns and structure co-investments?
Jessica Marlin: Sure—thanks, Isabel. If you went back a decade or so, there were two common structures for co-investments: Having the co-investors invest directly alongside the sponsor’s fund, or having the co-investors invest into an aggregator vehicle that itself invests alongside the sponsor’s fund. Some sponsors and co-investors alike would prefer to have co-investors come in directly because it eliminates a layer of cost—you don’t have to set up and run an aggregator—and, from a co-investor’s perspective, you are closer to the underlying asset. That said, having co-investors invest at the holdco level alongside the main fund has some meaningful disadvantages precisely because those co-investors are closer to the asset. For example, it adds extra parties to the negotiations with management (or conversely, exposes the management to the terms of the deal the sponsor is cutting with the co-investors), which can be a headache, to say the least, when a sponsor is trying to sign up a deal. It also adds complexity at the time of exit, because co-investors have to review and sign the sale documentation.
Today, the market has generally concluded that those disadvantages outweigh the marginal cost of setting up an aggregator vehicle, and we typically see co-investors routed through an aggregator that contains all of the core handholding, conflicts, expense, reporting and other provisions. That aggregator is the vehicle that signs the acquisition documents at the time of the initial purchase, and similarly, is the vehicle that signs any sale documentation. To the extent that the exit is via IPO, using an acquisition vehicle also helps with the group analysis, as the sponsor controls the acquisition vehicle and would make any required Section 13 filings on its behalf rather than having to coordinate with individual co-investors.
It is worth taking a few minutes to discuss some of the common regulatory questions that can arise in the context of co-investments, particularly as recently proposed rules from the SEC may shift the paradigm a bit. As discussed earlier, one point that co-investors typically do not want to bear is dead deal risks—whether the lead sponsor’s costs in pursuing the deal or any termination fees payable under the transaction agreements. Historically, the SEC’s view has been that a sponsor need not require co-investors to bear such amounts as long as investors in the sponsor’s fund were on notice as to how the sponsor might allocate such costs at the time of their investment, and most sponsors have been including such disclosure within their agreements. Nicole is going to take us through some of these regulatory issues that the SEC is considering now.
Nicole Krea: Thanks, Jess. That’s right—that has historically been the paradigm for expense allocation in the context of co-invests, but one of the SEC’s proposed private funds rules from February of this year, however, could change that paradigm. In particular, the proposed rule would prohibit an adviser from directly or indirectly charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment. Notably, the proposed rule does not include an explicit exception for omitting co-invest vehicles or other co-investors from fee and expense allocations related to dead deals. Rather, the proposed rule refers only to allocation among “clients” of the adviser—so, as currently proposed, to the extent that any particular co-investor or co-invest vehicle is not deemed a client of the adviser, such co-investors would not be obligated to share in fee and expense allocations on a pro rata basis (although the SEC could try to take the position that co-investors or co-investment vehicles are clients—a position we’ve seen on one or two exams). However, in the proposing release for the proposed rule, the SEC poses the question of whether the rule should apply to activities with respect to persons to which the adviser offers co-investment opportunities even if the adviser does not classify them as clients, thus leaving open the door to pull in non-client co-invest vehicles into the scope of this prohibition.
It’s important to keep in mind that, for now, this remains just a proposed rule. It remains subject to review and comment and, until a final rule is ultimately adopted, the actual impact will remain somewhat up in the air. Notably, the Commission does clearly have the impact on co-investments in mind, and has in the proposing release asked whether the proposed rule would make it difficult for funds to consummate larger investments where co-investment capital is needed or cause funds to syndicate more deals post-closing once the adviser is confident that the deal will not fall through. The SEC has also asked whether single-deal co-investment vehicles should be treated differently than multi-deal co-investment vehicles.
The practical effect of the provision as proposed, if ultimately clear that there is no exception for co-investment vehicles, would be to prohibit non-pro rata allocations across parallel funds, co-invest vehicles, and other clients that invest in the same deal. This would be a change in practice for many firms. For example, many clients currently will not allocate dead deal costs to employee co-invest vehicles (assuming their fund documents include adequate disclosure on that point). This gets particularly tricky with respect to deal-specific co-invest vehicles (where co-investors frequently refuse to pay such dead deal costs and where the co-invest vehicles are often not formed by the time a deal dies), and the SEC has asked for commentary on whether such vehicles should be treated differently than multi-fund co-invest vehicles.
Isabel Dische: Thank you, Nicole. It will be interesting to see whether and how those proposed rule are implemented later this year. Needless to say, there’s a lot to consider for both fund sponsors and fund investors.
Thank you, Adam, Jess and Nicole, 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 have 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 and Spotify. Thanks again for listening.
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