Few trends in the alternative investment industry have received as much attention over the last several years as co-investments. Co-investments have satisfied an appetite among numerous institutional investors to lower overall fees, reduce firmly committed capital and obtain greater exposure to select fund investment opportunities. Co-investments may also be viewed as an opportunity to put additional capital to work without having to onboard a new manager or to kick the tires with a manager under consideration for a more meaningful investment. Co-investments have become an expected source of capital for portfolio investments across all illiquid strategies: private equity, private debt, venture capital, real estate and natural resources. How prominent institutional investors fare in their various co-investment strategies will be watched closely in the coming years.
For all the buzz around co-investments in recent years, private fund managers often give relatively little attention to best practices in structuring the special purpose vehicle (if any) that will pool co-investor capital for a particular opportunity. This lack of attention is understandable given that co-investment capital is typically raised very quickly as the flagship fund prepares to close on the targeted investment. Frequently, fund managers will use the flagship fund’s governing documents as the template for developing the legal terms and conditions for the co-investment vehicle. Although this approach possesses a certain appeal because of manager and investor familiarity with the flagship fund documents, there are a number of areas where blindly following the flagship fund legal terms can create the potential for confusion and later disagreement among the manager and the co-investors.
Instead of structuring the co-investment vehicle as merely a “Mini Me” of the flagship fund, managers should be thoughtfully tailoring the co-investment documents to reflect the underlying investment as well as investor expectations. Questions to consider when preparing co-investment documents include, among others:
- Is the purpose clause for the co-investment vehicle narrowly tailored to the co-investment vehicle’s investment in the target company? For example, what if there are follow-on investment opportunities in the target company—do they belong to the co-investment vehicle, the flagship fund or others, or are they shared (and if so, on what basis)? Similar questions should be asked regarding any language related to future investment opportunities presented to the co-investment vehicle—who has priority?
- Has any language relating to recycling of capital from the flagship fund documents been addressed appropriately? Co-investors will generally be disinclined to allow recycling of invested capital in a co-investment vehicle, at least in our experience.
- Many co-investment vehicles pay reduced or no management fees. In that situation, the parties should consider how to handle ancillary fees received by the manager or its affiliates from the portfolio company. These ancillary fees—for example, portfolio company monitoring and consulting fees, director’s fees, transaction fees and the like—would typically be subject to a management fee offset in the flagship fund. Should co-investors receive their proportionate share of these fees as a rebate? Or should the manager be entitled to fully retain the co-investors’ share of these fees in light of the favorable management fee arrangement in the co-investment vehicle? Ideally, these concepts should be considered and addressed in the flagship fund documents at formation.
- Does the co-investment vehicle have tag-along rights (on a pari passu basis), so that it won’t be left behind if the flagship fund exits the investment? If so, is the co-investment vehicle’s liability for breach of the sale agreement joint or pro rata/capped at proceeds received by the co-investment vehicle?
- Does the flagship fund have drag-along rights so that the manager can assure that all funds and other investment vehicles managed by the manager can exit at the same time?
- Is dissolution of the co-investment vehicle linked to the dissolution of the flagship fund and/or the disposition of the underlying investment?
- How will organizational expenses be handled if the proposed co-investment is abandoned? Are the flagship fund documents clear in this regard? Should interested prospective co-investors be required to undertake to reimburse the sponsor or the flagship fund for their (estimated) share of broken deal expenses and any amounts expended toward the formation of the co-investment vehicle? In light of the SEC’s recent focus on this issue, a number of managers are clarifying in new flagship fund documents that all such costs and expenses will be borne by the flagship fund.
- How will ongoing expenses of the co-investment be handled? Will a reserve be created at closing or does the underlying investment generate distributions sufficient to cover such expenses? Alternatively, may the manager call additional capital to pay these expenses, and if so what is the maximum commitment?
- Have other provisions that make sense in the context of the flagship fund, but perhaps not that of a co-investment vehicle, been deleted? In this regard, consider whether annual investor meeting requirements, successor fund covenants, dedication of time covenants, key person triggers and GP removal rights are needed.
- If conflicts or valuations involving the flagship fund can be approved by an LPAC, should such approval be binding on the co-investment vehicle as well, barring a co-investment vehicle-specific reason to the contrary?
- What decisions with respect to the co-investment vehicle should require investor approval?
- Does it make sense to create a new GP entity for the co-investment vehicle, to isolate “clawback” or other claims?
- How will indemnification claims under the co-investment documents be funded, if the bulk of investors’ commitments are called in connection with the consummation of the underlying investment? Do the co-investment vehicle documents include appropriate investor “giveback” provisions and/or permit the co-investment vehicle to obtain insurance at the expense of the co-investment vehicle?
- Should the fiduciary provisions of the co-investment documents be clarified to state that the manager in making decisions with respect to the co-investment vehicle is entitled to consider not only the interests of the co-investment vehicle but also those of the flagship fund and any other funds or vehicles managed by the manager that are invested in the portfolio company, and that by taking into account these other entities, the manager may make decisions that are not as advantageous to the co-investment vehicle as those that might be made if the manager’s duties extended only to the co-investment vehicle?
- Should the co-investment vehicle documents restrict transactions by the flagship fund or the manager and its affiliates that could result in structural conflicts of interest relating to the portfolio company (e.g., investments in different classes of securities or at different levels of the overall investment structure)?
- Do the co-investment vehicle documents expressly state that the manager is not providing investment advice? In other words, do the investors acknowledge and agree that they are solely responsible for making their own decision as to the merits of any co-investment opportunity?
- Do side letters negotiated by co-investors with respect to the flagship fund also apply to the co-investment vehicle?
- If an investor is withdrawn from or excused from further investments of the flagship fund (for regulatory or similar reasons), does the manager have the right or obligation to withdraw the investor from any co-investments? Should an investor default under the flagship fund documents be treated as a default under the co-investment vehicle documents, and vice versa?
Alternative investment managers have clearly responded to demand in making co-investment opportunities widely available to institutional investors. Properly tailoring the legal terms of a co-investment vehicle can help minimize confusion and disagreements down the road that might otherwise sour an institutional investor’s experience with a co-investment and its manager.
 For purposes of this article, we are assuming that the manager has not formed a dedicated co-investment fund to invest alongside the flagship fund (though a number of the questions posed below would still be relevant in that case), and that co-investments will not be made directly in the portfolio company (or its holding company), which would raise a number of additional considerations that are beyond the scope of this article.
 Such disclaimers raise other questions, including how much information should be provided to potential co-investors regarding a co-investment opportunity and at what stage of the investment process such information should be provided, which are beyond the scope of this article.
Luis F. Ruiz