Offering co-investments opportunities: An investment funds trend on the rise

The most recent years have shown an increasing popularity of co-investment transactions across the funds industry. A co-investment opportunity is usually an investment offered by the fund manager of the main fund to the limited partners to invest alongside with it. Co-investment opportunities are attractive for both the fund manager and the limited partners as they provide direct access to hand-picked deals in selected profit-making companies and industries. However, the fund manager and the limited partners usually have their own interests when it comes to participating in co-investment transactions, sometimes resulting in potential opposing interests.

Co-investment opportunities: Potential opposing interests between the fund manager and the limited partners?

From the fund manager’s perspective, offering a co-investment opportunity to existing limited partners represents an alternative way to get around investment restrictions and diversification requirements of the main fund or to optimise the cash management of the main fund. From a strategic standpoint, the fund manager is often driven to offer co-investment opportunities to limited partners to create or enhance long-lasting business relationships with their limited partners. It is important to note that for co-investment opportunities arising in the context of a follow-on investment, the risk of the opportunity will be limited while maintaining an attractive return as the main fund already holds the initial investment for a certain period of time.

On the limited partners’ side, co-investment opportunities provide direct access to specific investments that limited partners would not have access to on their own because either the ticket size is too high for their investment capability or they have limited experience or knowledge in the investment sphere of the main fund. Furthermore, limited partners may be willing to have a more targeted approach to reach their own investment objectives like ESG investments or support specific sectors or industries while benefiting from the due diligences and analysis from the fund manager.

While limited partners may have an interest in participating or being offered the possibility to participate in co-investment opportunities, the other limited partners of the main fund will want to ensure that the offering, set-up and management of the co-investment opportunities by the fund manager do not take over its prominent role as fund manager of the main fund. The benefits of co-investment opportunities for the fund manager may lead it to take more interest in opportunities with a risk to neglect the management of main fund. The crucial issue at stake for the limited partners (in particular for limited partners not participating in the co-investment opportunities) is therefore to ensure that generating co-investment opportunities does not cause conflict with the interest of the main fund nor impair their initial investments in the main fund.

Overcoming the challenges of co-investment opportunities: A common approach on the market

Weighing the benefits of co-investment opportunities for both the fund manager and the limited partners has led to the development of a standard approach reflected in the legal documentation of the main fund. It provides appropriate safeguards to protect the interest of the limited partners while keeping a certain flexibility for the fund manager.

The first safeguard implemented in the legal documentation of the main fund is meant to ensure that the fund manager prioritizes the interest of the main fund over offering co-investment opportunities. This protection results in several obligations for the fund manager. A first set of obligations ensures that the co-investment opportunities shall only be offered when such opportunities are in the best interest of the main fund and provide investment terms identical or substantially similar to those applicable to the main fund and in no event more favourable to the co-investors than the main fund. The second layer of obligations imposed on the fund manager is to guarantee the investment position of the main fund before offering any potential co-investment opportunity making de facto the research of co-investments opportunities by the fund manager ancillary to the management of the main fund. Those obligations create a framework to remedy the main concerns of the limited partners regarding, notably, to mitigate conflicts of interests that may arise between the main fund and the co-investors.

A second safeguard aspect is the economics behind co-investment. Co-investment opportunities should offer reduced management fees and carried interests compared to those applicable to the main fund so that fund manager are not enticed to manage co-investment opportunities to the detriment of the main fund. Another important element is the allocation of fees and expenses incurred or to be incurred in relation to a co-investment opportunity. On this point, the market practice is clear that all fees and expenses have to be borne by the co-investors (including the main fund) pro rata to their respective amounts invested in such opportunity. And the main fund should not bear any costs in excess of its pro rata investment.

It is also standard to include a pre-determined order to be followed by the fund manager to offer the co-investment opportunities; this requirement ensures the limited partners of the main fund benefit from the services of the fund manager for which it has received a management fee as the fund manager already used the resources of the main fund to source the investment. The most standard order is to first make the co-investment opportunities available to the limited partners of the main fund on a pro-rata basis before offering the co-investment opportunities to third parties. However, the fund manager often reserves the right to invite one or more strategic third-party investors to participate in co-investment opportunities without first offering the opportunities to the limited partners.

Finally, the limited partners are keen to receive information from the fund manager to ensure the transparency of the fund manager and monitor the activities of the fund manager, in particular, its time dedication to the main fund. On this point, the approach taken by the market is to impose the disclosure of the co-investment opportunities to the advisory committee of the main fund.

It results from the foregoing that the attractiveness of co-investment opportunities comes with challenges to be overcome to enjoy the benefits of those opportunistic alternatives to traditional investments in private equity funds. If reviewing and negotiating the terms and conditions of the offering of co-investment opportunities is a prerequisite, other considerations will also be considered on the road to the co-investment. Indeed, a wide range of structuring options is available to fund manager and co-investors when considering a co-investment opportunity, the most common being the formation of a co-investment vehicle pooling the capital from co-investors, which may further raise additional questions and negotiations.