We continue to see an upward trend in private equity funds (“PE Funds”) utilizing co-investments. When properly structured, co-investment transactions can yield a number of benefits for both co-investors and PE Fund sponsors alike.
Co-investments in private equity are joint investments made by two or more investors, typically including a PE Fund sponsor and one or more limited partners. Each co-investor will directly participate in the equity financing of a particular target portfolio company (the “Portco”), alongside the PE Fund, as opposed to investing via the PE Fund itself. In doing so, co-investors can potentially gain greater exposure to a specific investment and increase their potential returns, while the PE Fund sponsor benefits from reduced capital requirements and potential access to additional investment opportunities. Typically, the PE Fund and co-investors will invest in a holding company (a “Holding Company”) that acquires the Portco, but they may also invest directly in the Portco.
While the primary goal of both the PE Fund and co-investors is to maximize investment returns, it is crucial to structure co-investments in a way that provides the PE Fund with sufficient operational flexibility while also safeguarding the interests of each co-investor.
This article identifies seven key considerations for both PE Funds and co-investors when structuring and negotiating co-investment transactions.
Key considerations and deal terms for co-investments
Active vs. passive
When considering co-investment opportunities, one of the primary considerations for a co-investor is their desired level of decision making with respect to the Portco. A co-investor might prefer to have ongoing involvement in the Portco following the closing of the transaction and therefore seek to make a direct co-investment in the Portco alongside the PE Fund sponsor. This structure is commonly referred to as an active co-investment. Alternatively, co-investors who are looking to have limited involvement in the majority of the decision making may choose to invest through a special purpose vehicle (“SPV”), often a limited partnership, which is created and controlled by the PE Fund sponsor. The co-investors pool their capital in the SPV which then participates alongside the PE Fund sponsor in the co-investment transaction. This structure is generally described as a passive co-investment. It is critical that the parties consider both tax and jurisdictional matters when structuring the co-investment transaction, though these points are beyond the scope of this article.
Alignment on exit strategy
PE Funds and co-investors must also consider the consequences of any liquidity events with respect to the Portco and/or Holding Company. Typically, co-investors will look to exit the investment at the same time and under the same economic terms and conditions as the PE Fund through negotiating certain tag-along or co-sale rights. PE Funds should consider how these co-sale rights could impact any decision by the PE Fund to syndicate their investment in the future and look to pre-negotiate carve outs to any co-sale right to allow for syndication if required.
To avoid the risk of a co-investor blocking a transaction by not agreeing to a sale, the PE Fund will want to have the right to force each co-investor to sell their interests when the PE Fund decides to sell, provided that certain requirements are met. The prerequisites to triggering the PE Fund’s drag rights may include a certain sale threshold being met (i.e., a full exit transaction as opposed to a partial sale) and/or achieving a pre-determined rate of return. In addition to negotiating the triggers to the PE Fund’s drag rights, co-investors should look to prohibit or limit the scope and duration of their non-compete and non-solicit covenants following a sale, as well as limiting the representations and warranties they provide upon a sale to fundamental representations and warranties relating to the ownership of their shares. Furthermore, while most co-investment agreements will place limitations on the transfer of shares, co-investors should look to negotiate the right to transfer their shares to affiliated entities and place restrictions on the PE Fund’s ability to enter into syndication arrangements absent the co-investors’ consent.
It is essential that the parties gain alignment on exit strategy as a dispute at the time of sale could detrimentally impact the proposed transaction with the third party. Pre-negotiating the terms of exit can reduce the potential for such disputes.
PE Funds and co-investors should carefully consider the board composition of the investment vehicle. Depending on the size of each co-investor’s investment, co-investors may negotiate the right to nominate directors to the board of the Portco and/or Holding Company. PE Funds may also be agreeable to granting a specific co-investor a board seat if that co-investor has a skillset or industry knowledge that can be instrumental to the support of the Portco. As the board of directors oversees the management and direction of the Portco, it is critical that the PE Fund and co-investors consider the board composition and its impact on the management of the investment. In addition, a co-investor should be cognizant that its nominee will have a fiduciary obligation to the Portco, which overrides any obligation to represent the nominating co-investor’s interests at the board level. This fiduciary duty does not apply to shareholders or unit holders, thus a co-investor should ensure that it has negotiated the right to veto certain board decisions as outlined below in its capacity as shareholder, to avoid the risk that its nominee is found to be in a conflict of interest based on advocating on behalf of the co-investor.
However, in cases where granting a board seat to a co-investor is not appropriate due to size of the co-investor’s investment, conflict of interest, or other reasons, the co-investor may instead seek an observer right. This right allows the co-investor to nominate an individual who may attend, but not vote at, meetings of the board of directors. While board observers do not have voting rights, and thus do not have a fiduciary duty to the Portco, they can be an effective tool for co-investors to monitor the decision-making activities of the board and ensure that their interests are being adequately considered and represented.
Minority approval rights
The right of a co-investor to approve certain actions or veto board decisions of the SPV or Portco are heavily negotiated in co-investment transactions. As the PE Fund often takes operational control of the Portco, co-investors will look to have the right to approve a pre-negotiated list of matters that they deem critical to protecting their investment.
When determining which matters should be subject to minority approval rights, the parties should consider the effect that such approval rights might have on the Portco’s ability to make decisions quickly and efficiently. Some of the more common minority approval rights that are sought by co-investors include the right to approve: (a) any amendments to the Portco’s constating documents; (b) the entering into of any material transactions outside the ordinary course of business (e.g., taking on any debt over a predetermined threshold, entering into a related-party transaction, amending the compensation of management of the Portco outside of ordinary course, or entering into a strategic relationship in which the contribution is greater than a predetermined threshold); (c) the entering into of any fundamental transactions outside the ordinary course of business (e.g., amalgamation, merger, reorganization or sale of all or substantially all of the Portco’s assets); (d) the authorization, creation or issuance of any class of securities of the Portco that impacts or has preference over any class of securities held by co-investors; and (e) the declaration or payment of any distribution, whether in the form of a dividend or return of capital. Whether a particular co-investor receives some or all of these approval rights depends on the nature of the co-investment, the role of the co-investor and the bargaining power of the co-investor.
In order to monitor their investment, meet their reporting and disclosure requirements, and hold management accountable, co-investors should look to negotiate rights to access and receive ongoing detailed information regarding the Portco. While certain corporate statutes mandate that shareholders receive audited annual financial statements (unless the corporation is not a reporting issuer and the shareholders unanimously waive the audit requirement on an annual basis), shareholders’ agreements will often provide shareholders the right to receive management-prepared monthly and quarterly interim financial statements, as well as management-prepared budgets and financial forecasts. In addition, co-investors should look to receive notice of certain events, such as notice of the commencement of litigation against the Portco. Co-investors must also consider their own internal reporting obligations and ensure that they can meet these obligations with respect to the Portco based on the rights they negotiate. As is the case with other minority protections, the scope of a co-investor’s contractual information rights will depend on the size of the co-investor’s investment and the type of co-investment transaction.
Co-investors should look to ensure that they have the right to maintain their ownership percentage in the Portco and/or Holding Company by negotiating robust pre-emptive rights on any future issuance of shares by the investment vehicle. Notably, there are certain equity issuances that are regularly carved out of the pre-emptive rights regime including issuances that are part of the Portco’s equity incentive plan and issuances in connection with a transaction that has received shareholder approval.
Fees and related party transactions
Investors who invest through a PE Fund will typically be charged management fees that are calculated as a percentage of the total committed capital. PE Funds will also charge incentive fees which equate to a percentage of the profits earned on investments by the PE Fund with such incentive fees becoming payable by investors only after a certain return threshold has been achieved. When an investor makes a co-investment outside of the PE Fund, the manner in which fees are charged differs when compared to investing through the PE fund. Where management and incentive fees are directly charged on co-investments, they are usually capped and lower than when investing directly into the PE Fund. Whether such fees are charged will depend on the needs of the PE Fund sponsor, as well as the form of the co-investment structure, including whether the co-investor is an active or passive co-investor. Co-investors should also consider what fees and expenses they will be required to cover relating to the investment, operation and sale of the investment vehicle. These fees are heavily negotiated and will impact the potential return on investment of each party.
Although the use of co-investment structures can lead to reduced or no management or incentive fees, co-investors may still bear indirect fees as the PE Fund, and/or its affiliate or another third-party, will typically charge management fees or other fees and expenses to the Portco and/or Holding Company. These fees and expenses are in consideration of the PE Fund managing the investment vehicle and/or providing other services, such as deal support. Consequently, co-investors should consider seeking contractual protections to prevent the PE Fund sponsor from increasing or introducing additional fee-bearing arrangements beyond what is disclosed and agreed to by the parties as of the closing of the initial investment. Such contractual protections may take the form of an approval right by the majority of co-investors or a covenant by the PE Fund sponsor to disclose to co-investors all fee-bearing arrangements between the Portco and/or Holding Company and the PE Fund sponsor (or any of its affiliates). An alternative approach would be to require that all such arrangements be entered into on arm’s-length terms, though it may prove difficult to demonstrate that a particular fee-bearing arrangement between the Portco and/or Holding Company and the PE Fund sponsor does not reflect arm’s-length terms. Any restrictions on fees should be reasonable to reflect the services to be provided by the PE Fund sponsor.
Co-investments will continue to play a significant role in private equity due to the advantages outlined in this article. It is critical that both co-investors and PE Funds carefully consider the various ways in which co-investments can be structured in order to ensure that all parties are aligned and working towards a common goal of creating value for investors. The parties should look to strike a balance between the need for co-investors to protect their investment and providing the PE Fund sponsor with the latitude to make operational decisions based on its expertise so that it may maximize returns.
Should you have any questions, please reach out to a member of Miller Thomson’s Private Equity Group.
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