Co-investments – a guide for investors

Co-investments have been around for some time and their popularity shows no sign of abating. They offer fund sponsors and investors a raft of benefits, from lower blended fees to increased fire power when doing deals. However, there are many bear traps out there for investors, which may not be obvious to the untrained eye. The purpose of this article is to highlight some of these risks and help investors steer a course through various issues.

Watered down

Key investor protections are not necessarily uppermost in a sponsor’s mind, but they are important. Anti-dilution protection ranks among the most important minority investor rights that an investor should look to negotiate in any co-investment deal. Such protection can be achieved by having watertight pre-emption rights on the transfer and issuance of new securities. Further, the fundraising period for the admission of new investors should be limited, and the price they pay to acquire their interests should be defined. Co-investors may also want to have a veto or information rights in relation to key decisions affecting the financing or business of the target company.  

I can see clearly now

Co-investors should ensure that they have sufficient information rights under the governing documents of the target business to enable them to report to their own investors, meet tax filing requirements and track the performance of their investment. Investors with a big enough stake in the vehicle may be able to secure Board observer seats and enhanced information rights, such as monthly management reports and copies of Board information packs. Further, investors need to carefully review the disclosure provisions in the fund documents to ensure they can disclose information received from the
fund to their own investors and prospective investors, as part of their own marketing efforts.

Return of the cash

The limits on investor givebacks in co-investment LPAs have been eroded in recent times - and may even vary from deal to deal with the same sponsor. The rationale offered by sponsors is that, as the vehicle owns a single asset, there should not be any arbitrary limits on amounts that can be recouped to meet indemnification obligations, other than on the amount of distributions received by the co-investor. Investors should be wary of this and should always read the small print (or ask Ashurst to do so on your behalf), because the devil is in the detail. 

Merry-go-round

Continuation funds and sponsor-led secondaries are all the rage these days, with sponsors willing to hold on to assets that are performing well, while realising an upside (read: carried interest) along the way. Investors need to be careful that the LPA does not allow the sale of the asset to another vehicle managed by the sponsor without its consent. Further, investors should try to secure some level of control in terms of valuations of assets that are being sold to another sponsor-managed vehicle, as well as the right to exit at the time of the sale on a secondary basis if the investor is not happy with what is being proposed. 

A sprint, not a marathon 

Co-investments are often carried out at breakneck speed: we have advised on co-investments that have closed within one working week from the point of instruction. Even where the time frame is more generous, co-investments always carry a sense of urgency. To avoid this, investors should maintain an open dialogue with sponsors to improve visibility around co-investment opportunities and to ensure that their advisers receive their instructions as early as possible to avoid any delays. Investors should also ensure that time frames for pre-emption rights for follow-on investments are workable in practice.

Ca$hmoney

Even with the better economics on offer, investors should be alert to the sponsor’s ability to recoup its reduced fees through transaction fees and broken deal fees at the sponsor fund level and/or at co-investment vehicle level. Investors should seek full disclosure at the outset of the transaction of all additional fees charged by the sponsor, as co-investment LPAs are often drafted in an opaque manner.
Equally, investors should be mindful of the sponsor’s ability to engage its affiliates to provide services to the co-investment vehicle or its assets – such fees should always be on arm’s length terms.

Same same, but different

Where an investor is committing to a new co-investment opportunity within an existing manager relationship, it should ensure that the terms of the LPA and the side letter are consistent with the terms of the precedent transaction. This not only speeds up the process of reviewing and negotiating the terms of the documentation, but also provides consistency across multiple deals. An investor’s lawyers should be proactive in chasing responses to comments from sponsor’s counsel to ensure that investors are not presented with a “take it or leave it” position the day before closing. 

Don’t forget your keys

Co-investment LPAs rarely contain any protections for key persons. Instead, fund sponsors point investors towards the protections in the main fund LPA, which may not be helpful if the co-investor is not an investor in the main fund. It is important that the two documents are linked, so that any key person event which occurs at the level of the main fund and leads to a termination also triggers a termination
right at the co-investment vehicle level. 

Cause and effect

Cause removal provisions – like key person protections – are often absent from co-investment LPAs. Instead, investors are directed towards the removal provisions in the main fund LPA. If there are no removal provisions, investors should have visibility over removals at the main fund level, with the option of removing the general partner at co-investment fund level if a removal at the main fund occurs.

Death and taxes

Investors need to ensure that their tax advisers are up to speed with their tax requirements, so that they can cut through the issues quickly and advise on whether the proposed investment structure is workable. Further, tax advisers should quickly get on top of the information rights and tax obligations of the sponsor to ensure they meet the investor’s needs. 

Due diligence

Investors should be comfortable with the sponsor’s due diligence procedures and reports. Alternatively, they can take matters into their own hands, in which case they will need a team in place with the right skills and experience to do the deals. Building a deal team is neither cheap nor easy, and it can take time. 

Understandably, the sponsor will want to put the onus on investors to independently review the co-investment opportunity so as to reduce reliance risks. Investors who are content to sign off on the due diligence reports and paperwork prepared by a seasoned sponsor may be less inclined to do so with a first-timer. In any event, investors should always feel comfortable that their investment is a
sensible one – given that recourse to the sponsor may be limited if it is not.

Regulation station

Merger control and FDI issues can derail a co-investment for both the sponsor and the individual co-investors. Specialist counsel should be brought up to speed on the co-investment as early as possible to ensure that there are no merger control issues or FDI filing requirements lurking in the transaction.

Who are you?

Finally, let’s not forget everyone’s favourite topic: AML/KYC. These processes take time, so investors need to be able to move quickly to provide the information required by fund sponsors and their administrators. Chasing feedback from the sponsor is just as important - receiving a lengthy list of KYC/AML follow-up requests the day before closing can be hugely problematic. We recommend building a bank of KYC documents from previous deals to ensure you are well prepared for requests from the sponsor or its administrators. 

Finally, co-investments are very much here to stay and the demand from investors for access to good deals is high. Deal time frames are often ludicrously tight, so investors should ensure that their advisers can move quickly and negotiate effectively. We are well versed in the art of closing co-investments for investors and would be delighted to discuss any opportunities that may land on your desk.