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Institutional investor interest in private equity co-invest opportunities does not appear to have diminished over the last few years.  Fund sponsors across a variety of asset classes (private equity buy-out, real estate, natural resources) have provided a robust and steady offering of co-invest opportunities recently.  Even hedge fund managers are occasionally offering co-invest opportunities in place of, or sometimes in addition to, side pockets on illiquid assets.  What risk does an institutional investor face when it invests in a fund sponsor that, as part of its capital-raising strategy, expects to offer co-invest opportunities outside the fund group?

Co-invest conflicts for fund investors can arise from two principal sources.  The first is large, sophisticated investors who view co-invest opportunities provided by the fund sponsor as important as, or even more important than, their investment in the fund. These investors may be able to formally or informally commit enough capital to a fund sponsor’s co-invest opportunities that they are able to over allocate to select portfolio opportunities on a cherry picking basis.  But even if a large investor co-invests consistently across the entire fund portfolio, there is nonetheless potential dilution of the fund’s investment opportunities.  An investor may be comfortable with a fund raising $1 billion in commitments.  However, if $500 million in co-investment capital is expected to be raised, the investor may lose conviction that there will be a sufficient number of high-quality portfolio investment opportunities to invest an aggregate of $1.5 billion in the sponsor’s strategy—even if the co-investments are made consistently across the fund’s portfolio.

Typical fund limited partnership agreements give a high degree of flexibility to fund sponsors to vary the percentage that co-investors are able to invest in each portfolio opportunity.  For example, a co-investment policy expressed in a recently-reviewed fund limited partnership agreement, states as follows:

The General Partner may, in its sole discretion, permit one or more of the Limited Partners…to co-invest alongside the Partnership in one or more Portfolio Companies….[T]he General Partner, in its sole discretion, shall allocate the available investment among the Partnership and the Persons, if any, who are co-investing….

It is understandable that fund managers are given a wide degree of flexibility in seeking capital from select co-investors, rather than potentially losing a favorable portfolio investment if additional capital cannot be raised quickly.  However, the latitude of some co-invest policies appears to go beyond the need for readily available supplemental capital to close a desirable investment.

One possible resolution to avoid the potential of cherry picking and general dilution of fund investment opportunities is to cap the amount of co-investments in the fund’s investment strategy that the firm sponsor may undertake during the fund’s investment period.  The cap might be expressed as percentage of the fund’s capital commitments, possibly in the 20 to 40 percent range.  A weaker form of this provision might allow co-invests above the cap, but any co-invests above the cap would require management fees and carried interest be charged on the co-investment at the same rates as paid by fund investors.

The other possible conflict with a co-investment policy such as the one described above is that it does not distinguish between investors that are affiliated with the fund sponsor and those that are not.  Literally read, the above co-investment policy would allow a fund investor affiliated with the fund sponsor to make selective co-investments on a cherry picking basis.  Such conduct would arguably run counter to the fund sponsor’s fiduciary duties under the Investment Advisers Act, although the fact that a limited partner has consented to a broadly worded co-investment policy is not likely to be helpful to an investor seeking to make that claim.  Investors may consider clarifying with the fund sponsor that any co-investments by a sponsor-affiliated co-investor should be made pro rata across all available co-investment opportunities, unless the sponsor can demonstrate that a larger investment by affiliated investors is needed in order not to lose the investment opportunity.

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Luis F. Ruiz

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