Broadly, a co-investment is an investment in a specific transaction made by limited partners (LPs) of a main private equity (PE) fund alongside, but not through, such main PE fund. This is often accomplished through a separately structured co-investment vehicle which is governed by a separate set of agreements. Co-investments are attractive to PE funds and LPs alike for a multitude of reasons, including as: a means for PE funds to gain access to supplementary capital; an avenue by which PE funds may make larger single investments that are otherwise unavailable or undesirable; and a means for LPs to attain enhanced diversification and a larger share of desirable investment, among others.
A Practical Look at Co-Investment
Co-investment arrangements can provide benefits and value to both LPs and PE funds. An investor in a PE fund will often indicate (commonly in the subscription agreement or a side letter entered into with the fund) whether it is interested in co-investment opportunities. Such election by the LP is informational and should not impose any obligation on the general partner (GP) of the fund.
GPs will offer co-investments to some or all of the LPs. Co-investments may offer LPs a bigger stake in investments of interest, without as much of the diligence and procedures typically associated with an investment opportunity. LPs may also gain access to enhanced due diligence or GP materials that would otherwise be unavailable, allowing for deeper understanding and enhanced tailoring of such LP’s investment portfolio. From a fund’s perspective: sharing investment risk, increased access to investor capital, and the marketing and investor relations benefits with specific investors outside of the main PE fund are additional attractive characteristics.
To ensure fairness and transparency, PE funds and LPs should consider and implement best practices including robust disclosure, fairness of allocation and alertness to potential conflicts of interest. A well-structured co-investment vehicle, with diligently prepared fund agreements and related documents, can address and alleviate many of the potential pitfalls.
Co-investment vehicles are often structured with similar governing documents to those of the main PE fund. The co-investment vehicle through which a co-investment is made, and the agreements that underlie the vehicle, are important and should not be overlooked. The particular nature of the co-investment relationship, and the interplay with the main PE fund, should be accounted for, including as it relates to: allocation of expenses and payment of fees; apportionment of opportunities; voting; and responsibilities of management.
A framework for co-investment by the main PE Fund should be carefully considered and mapped out at an early stage, with a view of communicating to LPs concisely and as early as possible. A fund’s offering documents and governing agreements should, in reasonably clear terms, provide the lay of the land.
Co-investment vehicles may be used for jurisdictional and tax planning efficiency. Since the tax and regulatory aspects of the fund, investment and investors are known at the time of the transaction, parties have the ability to customize co-investment structures to account for tax-related considerations well in advance. Tax advice should always be sought when addressing particularities of structure including relating to the provision of management services, auditing and reporting obligations.
Co-investment program goals and expectations
An investor will be better equipped to select appropriate co-investments if it establishes clear and objective investment criteria, return expectations and relationship benchmarks. Having transparency allows all parties to better monitor investments and make more informed, timely and appropriate decisions regarding any issues that may arise such as funding or exiting.
In addition to the above, several aspects of a co-investment structure can affect a co-investor’s return – requiring commensurate attention and planning, including:
- Regulatory issues, including reporting requirements and compliance with jurisdictional securities laws. Co-investors may also be faced with regulatory concerns that can be transaction- or industry-specific, commonly including telecommunications, gaming, or publishing industries;
- Costs to the investors, including transaction fees, payment of carry and management fees;
- Compliance with investment mandates and fund goals, in order to create synergy between co-investor and fund interests;
- Control over portfolio company decision-making; and
- Ability to be a good co-investment partner, including making quick initial decisions, allowing for the ability to monitor, review, and adapt to changing information, and establish internal processes and procedures for investment decisions and monitoring.
Co-investments can be a useful and important tool for PE funds and PE fund investors. While often nuanced, and sometimes unsuitable, the flexibility afforded by co-investments and co-investment vehicles can provide upside for funds and LPs in the right circumstances.
Speak with a member of our Private equity and venture capital team for assistance or questions when exploring co-investment arrangements.
The author would like to thank Daniel Lupinacci, articling student, for his assistance in preparing this legal update.
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