Co-investments have long been a feature of the private equity buyout market. GPs typically allow themselves some leeway to choose and bring co-investors into select deals, e.g. if a portfolio company equity investment is too big for a single fund or would breach pre-agreed concentration limits. LPs get increased exposure to select investments, and it’s cheaper than an equivalent blind-pool commitment because co-investments benefits from reduced (or zero) management fees/carry.
Even with favourable economic terms, prospective co-investors should still tread carefully. Here are eight more questions they should ask when getting into “classic” co-investments, in which they take a minority stake (directly or indirectly) in the investee company alongside the fund:
1. Is the co-investment allocation fair?
An investor’s co-investment allocation is often documented in a side letter with the GP. This is an area that the U.S. Securities & Exchange Commission has recently turned its attention to, having identified instances where investors were not made aware that other investors had negotiated co-investment priority rights (e.g., a fixed percentage of co-investments will be allocated to a favoured investor). The SEC has hit out at U.S. managers, saying that more openness is required, especially now that co-investment allocation is increasingly becoming an important factor for investors in deciding whether to invest in a particular fund.
2. Are there sufficient investor protections?
Not necessarily uppermost in a GP’s mind, it is important to remember key investor protections. For instance, investors should be wary of a manager being able to issue debt or equity-like securities to third parties (or, even worse, affiliates) that have the effect of diluting a co-investor’s economic stake in the underlying investee company. Anti-dilution protection ranks among the most important minority investor rights that an LP should negotiate in a co-investment deal. It can be achieved by having watertight pre-emption rights on transfer and issuance of new securities. The LP may also want to have veto or information rights on key decisions affecting the investee company’s financing or business.
3. Why this deal in particular?
It is unwise to simply rely on the fact that the main fund is investing in the same transaction. It is worth considering why that particular deal is up for co-investment. As mentioned above, it could be that the main fund can’t do the transaction alone because it has already reached its maximum permitted exposure. Alternatively, the manager may not rate the deal as one that will likely produce high returns, but it needs to deploy capital before the fund’s investment period expires. Don’t forget that one of the advantages of investing in a fund in the first place is to diversify risk, whereas a co-investment increases an LP’s deal-specific risk.
4. Who else is co-investing?
Investors need to remember that fellow co-investors will often have different strategies and it will be important to establish from the outset how the investment will be run, and that no one is getting more favourable terms. It is especially important to know if a co-investment will need follow-on or emergency capital, as this will impact on an LP’s own cashflows and risk management.
5. Is the manager over-exposed?
The importance of GP’s ‘skin in the game’ is clear, but if the managers have invested too much personal wealth in a particular co-investment, they may be tempted to allocate most of their time and effort to getting the best out of the co-investment, which could have a negative effect on the main fund’s other investments.
6. Is the necessary expertise in-house?
If an LP’s principal business is to select funds to invest in, that requires a markedly different skill set compared to the GP’s day job of evaluating and managing direct investments. Managers need co-investors to have the skills, capital and capacity to respond quickly and flexibly in acquisition and management situations. LPs who want to be valued co-investment partners for managers need to boost their investment expertise, and have the resources to carry out necessary due diligence and make investment decisions promptly.
7. Is the advisory board still independent?
If the majority of members of a fund’s advisory board are co-investors in a particular investment, investors need to question whether they will be acting in the best interests of the main fund or their own interests in relation to a particular co-investment. If the advisory board is composed mostly of co-investors, arguably they are longer an independent check on the GP’s management of that investment on behalf of the fund’s other LPs.
8. What will happen if the staff change?
Be wary of relying too heavily on current relationships. Remember that it is likely that an investor will be holding on to an investment for over five years and management teams change. As a result, strong legal protections are essential regardless of the current relationships.
With institutional investors under pressure to grow returns, we are likely to see co-investments become even more popular. But even with the better economics on offer, LPs should be cautious and prudent when analysing and negotiating them, and be prepared to devote resources to building a capable direct-investments team – which may have other long-term strategic benefits for any LP that does succeed in that endeavour, because it could eventually become less dependent on higher-cost external managers.