The Co‑Investment Continuum: Direct and Indirect Structures That Empower Lps (Part Two of Two)

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April 28, 2020 CO-INVESTMENTS The Co‑Investment Continuum: Direct and Indirect Structures That Empower LPs (Part Two of Two)

By Dietrich Knauth, Private Equity Law Report

Co‑investments come with certain challenges Opportunities in the Private Equity Industry, and risks, including the potential to inhibit a Along With Attendant Deal Flow and Fee GP’s ability to close deals, exit investments or Structure Issues” (Dec. 8, 2016). maximize value for investors in its main PE fund. GPs may lack the negotiating leverage LP‑Controlled to avoid those issues, however, as LPs in co‑investments seek increasing amounts of Co‑Investment Structures control and access. That is particularly the case when an LP is an anchor investor in a sponsor’s Co‑investment structures are sometimes main PE fund or where a sponsor has a limited driven, at least partly, by LPs’ negotiating track record. In those contexts, GPs have several power. Most LPs are drawn to co‑investments options for structuring their co‑investment as an opportunity to average down the programs to meet LP desires while potentially management fees and carried interest paid protecting their own interests. to GPs across their PE portfolios. Some LPs, however, also desire the ability to take more This two-part series describes common control over their PE exposure and obtain co‑investment structures and the factors a fund more direct access to deals in a way that sponsor must consider when deciding which would be impossible through blind-pool fund approach to offer its LPs. This second article commitments alone. outlines direct and indirect co‑investment structures that afford LPs more discretion on Those LPs want the ability to select individual which investment opportunities they will pursue co‑investment opportunities, or the option to or bypass. The first article addressed longer- shape their exposure to promising companies, term structures GPs can use to pursue several industry sectors or geographic regions. co‑investment opportunities, including to give Other LPs want to use co‑investments to seize the sponsor more control over LPs’ some control over the pace of their capital co‑investment commitments. commitments to GP. Finally, some LPs view the co‑investment process as an opportunity to See “Sadis & Goldberg Seminar Highlights the work more closely with a GP as a form of Ample Fundraising and Co‑Investment training for their internal investment staff or

learning more about investing in a particular they typically attain via voting or observer industry. seats on the underlying company’s board of directors. Those enable co‑investors to In light of those desires, PE sponsors often communicate directly with the company’s consider the following co‑investment management team and receive information structures to grant proactive LPs more typically provided to other stakeholders autonomy and discretion in the process. (e.g., lenders), said Latham & Watkins partner Amy R. Rigdon. “In a direct co‑investment, See “Recent Trends in Key PE Terms Impacting the LP can be more of an active participant Alignment of LP and Manager Interests” – particularly if there’s no holding company (Nov. 19, 2019). and they’re going directly into the portfolio company, they arguably have a lot more insight Direct Investments into the portfolio company.”

One approach is for PE sponsors to allow See “Current Scope of PE‑Specific Side Letter co‑investors to take direct equity stakes in a Provisions: Co‑Investment Rights, LP Advisory portfolio company. The appeal of this structure Committee Seats and Parallel Funds/AIVs can sometimes be driven, at least in part, by (Part Two of Three)” (Mar. 26, 2019). particularities of the deal in question. For example, a GP pursuing a deal with only one or Factors to Consider two co‑investors might consider it more efficient to set it up as a direct co‑investment When considering whether to offer a direct instead of setting up a separate legal structure co‑investment, a GP must take into account for the co‑investors. a range of factors, including the number and identity of co‑investors; regulatory issues; and Although a direct investment in a portfolio tax concerns. For example, direct co‑investments company seems straightforward, there are are “typically more favored by institutional several different ways that type of investors with some wherewithal about co‑investment can be structured, including: investing,” said Rigdon.

• LPs acquire a minority stake directly in See “Regulatory Risks and Important Tax the portfolio company; Considerations in PE Co‑Investments (Part • LPs purchase a minority stake in a holding Two of Two)” (Jun. 25, 2019). company co‑owned by the co‑investors and the fund’s LPs; or In addition, a GP’s status can factor heavily • all or some of the LPs invest in the into whether a direct co‑investment approach underlying company through a blocker is pursued. The structure is more common corporation for tax or governance where LPs have greater negotiating leverage, purposes. such as when they are an anchor or seed investor in an emerging manager’s fund. In Regardless of how they are structured, direct those scenarios, GPs have an incentive to co‑investments are appealing to investors concede more control in a co‑investment to because of the increased information rights appease the LP.

Further, the structure can be used to allow Typically, GPs structure the direct co‑investments co‑investors to become acquainted with an to maintain full control over those decisions, emerging manager with a limited track record. but that is harder to accomplish than in “An institutional investor may be less familiar situations when co‑investors invest indirectly. with the independent sponsor that sourced “The control isn’t to be greedy; there are some the co‑investment opportunity than with real legal concerns around control because established sponsors of blind-pool, committed the GP has a fiduciary duty to its main fund,” PE funds, said Winston & Strawn partner noted Rigdon. Bradley S. Mandel. “In that case, the LP may be looking for more protections, control and If co‑investors have increased rights and direct information rights than if it were co‑investing access to a portfolio company, the GP needs to alongside a sponsor with whom it’s invested carefully balance its foregone control with the in five or six funds.” fiduciary duties owed to investors in the main PE fund, advised Rigdon. “It’s a little bit easier See “How Emerging Fund Managers Can Raise to feel like everything’s aligned when you’re Capital in a Challenging Market Without using a co‑investment vehicle that’s pari passu Overstepping Legal Bounds” (Aug. 4, 2016). with the main PE fund because the sponsor controls both and can make decisions affecting Risks of Direct Co‑Investment both sets of investors the same way.”

Direct co‑investments can be risky, however, Further, a direct co‑investment can delay for GPs preferring to maintain strict control completion of a deal in the first place because over purchasing, operating and exiting a more owners are involved. “It is difficult on the portfolio company. If a direct stake is not best days to negotiate the transaction carefully structured, then the alignment of documents and close an acquisition on time, interests between the fund investors and the but the process can be slowed further if more co‑owners of the portfolio company can be co‑investors are directly involved in the frayed. For example, a co‑investor could seek process,” observed Rigdon. “It can also irritate to retain its minority stake after the main PE the portfolio company because now it has ten fund exits the investment or use its seat on buyers instead of just one. “ the company’s board of directors to undermine the GP’s operation of a portfolio company. To mitigate those risks in a direct co‑investment context, a fund sponsor may For another structure carrying alignment risks, require co‑investors to grant the sponsor a see our two-part series on structuring PE proxy to control the vote for co‑investors’ club deals: “Overview of the Process, Possible ownership stake. A similar proxy may also be Structures and Their Recent Evolution” arranged if the co‑investors own shares (May 7, 2019); and “Key Deal Documents and through a blocker company for tax purposes. Eight Essential Practice Tips to Navigate Deals” (May 14, 2019). See “Investment Vehicles, Investor Rights and Restrictive Covenants in PE Co‑Investments (Part One of Two)” (Jun. 18, 2019).

Indirect Co‑Investments each co‑investment in a portfolio. “That works well if you have a lot of the same investors Another option GPs typically prefer is to use a putting up the investment dollars,” observed co‑investment vehicle that creates an indirect Corelli. “It is also effective if there’s no liability ownership relationship for the participating LPs. that passes through for the underlying portfolio companies; for example, you wouldn’t Corporate Structures use it with certain types of oil and gas investments.” The approach often involves forming a vehicle – either a special purpose vehicle In a series-based entity, each series’ assets are (SPV) or another corporate structure – that insulated from the liabilities of the other series pools co‑investment ownership, although a by statute as long as each series’ books and number of complex variations are possible. records are maintained as if they were separate For example, the main PE fund’s investment partnerships. Conversely, a class-based entity can be through one corporate structure and allows a sponsor to contractually achieve the the co‑investors’ commitments through a same results without keeping separate books different SPV, with blocker structures used for and records for each class, explained Corelli. “I shareholders of each as needed. happen to prefer the class-based approach because, with series-based vehicles, you might Although it is more work for the vehicle to be as well have one partnership for each deal and formed on an ad hoc basis for each series. The only things you’re saving are the co‑investment, that approach is popular for franchise fees and formation costs in the state allowing a GP to vary the terms according to in which you formed.” the needs of the deal or group of participating co‑investors, noted Rigdon. The peril, however, See our three-part primer on deal-by-deal is that LPs generally have more room to funds: “Structural Overview and Investor negotiate the terms of their participation, Perceptions Affecting Adoption” (Feb. 18, 2020); added Pepper Hamilton partner Julia D. Corelli. “Key Fundraising and Structural Considerations” “LPs will say, ‘we don’t want to pay this, or (Feb. 25, 2020); and “Balancing Deal Uncertainty want to receive that,’ and you’re at the whim of Against Attractive Carry Opportunities” the people who have the money that you need (Mar. 3, 2020). to close the deal.” Potential Pros and Cons For more insights from Corelli, see “Study Describes PE Co‑Investment Trends and GPs often prefer indirect co‑investments, as Manager Reluctance to Disclose Deficiencies they generally allow them to retain more (Part Two of Two)” (Mar. 26, 2019). control over the arc of the process. GPs can structure the co‑investment vehicles to always Alternatively, a pre-negotiated, “evergreen” vote in tandem with the main PE funds on co‑investment vehicle can be used, which is decisions like selling a portfolio company, or only adapted to meet the needs of a specific otherwise ensure the co‑investment vehicles deal. That vehicle can be a class- or series- operate in lockstep with the main PE funds. based entity, with a single class or series for

In addition, indirect co‑investment structures Although a good idea in theory, GPs prefer not also appeal to co‑investors by enabling them to to use pledge funds because they do not negotiate for many of the information and improve LP uptake on individual co‑investment observation rights typically available with a opportunities or save GPs from creating direct co‑investment. “If GPs are willing to give multiple corporate structures on ad hoc bases. minority governance rights to sizable “Pledge funds are probably the least prevalent co‑investors, that can still occur through a of the co‑investment programs because they co‑investment vehicle,” noted Rigdon. “Large, are a lot of work to bring together without anchor co‑investors can receive board seats or providing GPs meaningful certainty,” observed observer seats at the portfolio company despite Rigdon. “You’ve created a structure with no investing through a co‑investment vehicle.” commitments where participants retain their Indirect structures are not without drawbacks, ability to decide whether to participate in however. They are generally more cumbersome particular co‑investments.” and costly to establish and run than the direct co‑investment approach. In addition, having In fact, using a pledge fund to offer the same GP in charge of multiple vehicles co‑investments can complicate the process with overlapping financial interests requires for GPs by requiring them to establish and additional attention and care to avoid conflicts fundraise for the fund while simultaneously of interest. negotiating commitments to the main PE fund. “It can be a useful tool, but it can divert See “What Legal, Regulatory and Operational time and attention away from the main fund Challenges Do Single‑Asset Funds Present for negotiation, which is what everyone’s focused Managers?” (Mar. 24, 2020). on,” said Simpson & Thacher partner David J. Greene. “That attention can be difficult to Pledge Funds justify for an ancillary product when there might not yet be a deal to co‑invest.” Another approach that PE sponsors can use to grant co‑investment opportunities is by using Also, pledge funds also create questions about a pledge fund, which involves a soft investor fees and the mechanism for funding commitment to the fund that affords LPs commitments, added Greene. There are flexibility to join investment opportunities at expenses associated with the vehicle that the their discretion. GPs typically have some sponsor needs to pay despite there being no protections, however, as investors are penalized guarantee of deals, he noted. “An LP may make or removed from the fund altogether if they an upfront commitment, but that can’t be forgo too many investments, either in total drawn down for an investment unless the LP or consecutively. permits it or makes a specified commitment for each individual investment,” he explained. See our three-part guide to pledge funds: “High “So, a source of funds is needed for costs from Upside Fee Structure and Other Incentives for creating and operating the vehicle, which are Adoption” (Apr. 9, 2019); “Key Investment often carefully scripted in the pledge fund’s Management Agreement Provisions” (Apr. 16, limited partnership agreement.” 2019); and “Deal Uncertainty Issues and Three Investment Vehicle Structures” (Apr. 23, 2019).

Those reasons, among others, account for the limited adoption of pledge funds in the co‑investment context. “I know of some large PE shops that have those types of programs, but they’re not as popular as direct co‑investments, committed co‑investment funds (i.e., ‘top-up funds’) or single-asset co‑investment vehicles,” explained Rigdon.

Instead, pledge funds are often used to test the waters with an emerging manager or fund- less sponsor before making a traditional PE commitment, Rigdon observed. “Emerging managers use pledge funds to generate track records and generate some momentum to maybe raise a blind-pool fund or grow a blind- pool fund.”

For more on emerging managers, see “Investor Gatekeepers Advise Emerging Managers on How to Stand Out When Pitching and Marketing Their Funds” (Dec. 15, 2016).