Total GP discretion

The first thing to know about terms and conditions in co-investing is that LPs who even get the chance to discuss terms and conditions have cleared a significant hurdle.
As private equity deals grow ever larger and diversification restrictions remain in fund agreements, general partners are seeking new ways of funding deals. At the same time, limited partners are eager to deploy large amounts of capital alongside favored managers.
One solution that matches this supply and demand is a sidecar fund, which only some of the largest GPs, like Bain Capital and The Blackstone Group, have raised. Another option is bringing investors, either LPs in the main fund or third parties, into transactions on a deal-by-deal basis.
The co-investment itself is specific to a transaction: the GP, upon sourcing a deal that exceeds concentration limits set in the main fund agreement, invites investors to put up additional equity to close the deal.
There are two main ways GPs can structure a co-investment. The GP can allow investors to come directly into the portfolio company as normal shareholders. Alternately, the GP can create a special purpose vehicle set to expressly acquire the company; the GP controls both this vehicle as well as the underlying investment. The latter structure is popular in the US and becoming increasingly so in the Europe under the new Markets in Financial Instrument Directive.
There are advantages to be had in a co-investment for both GPs and participating investors. For GPs, it means the ability to do bigger deals while retaining control of an investment than otherwise possible in a club deal. For LPs, the most attractive feature of a coinvestment is the reduction or elimination of management fees and carried interest on a portion of the investment.
What participation in a co-investment means for investors is twofold. First, the investor must be able to act quickly when the call from the GP for a co-investment opportunity comes. Upon signing a confidentiality agreement and receiving due diligence material, the investor must be able to do its own due diligence, make a decision on whether to participate in the co-investment and arrange funding within a matter of weeks, if not days. Where the co-investment opportunity is syndicated to investors after the GP completes the deal, speed is also important for the GP in unloading the portion of the equity it doesn’t want to hold.
Second, the investor normally has to be content with a passive investment. Investors usually do not get voting control or management rights, but they may occasionally get a board observation seat in the portfolio company. An investor’s negotiation power depends on the proportion of its investment and the GP’s discretion. Although the interests of both the GP and investors are aligned in a co-investment, the risk is also higher for the investor due to the standalone nature of the deal. If the investment goes awry, there will be no gains to offset it, as is the case with most funds.

Getting a foot in the door
Getting to the point of being given the opportunity to co-invest can be a struggle for an investor. The battle begins in the main fund agreement. In the past LP agreements contained LP rights to co-investment opportunities, but this is no longer common. LPs are finding it hard even to secure side letters offering access to co-investment opportunities as the power GPs have keeps increasing.
“What you find is a competitive tension between GPs and LPs when raising a fund as to what this clause [regarding co-investment rights] is going to say,” says Jason Glover, a partner in the London office of law firm Clifford Chance. “Typically you will see a clause that gives the GP complete discretion. It simply says, ‘The GP may offer such co-investment opportunities available to such persons as it shall in its sole discretion decide.’”
A US-based LP echoes this state of the market: “I can’t think of one fund agreement in the past three years that says, ‘Here’s your co-investment right.’”
The LP goes on to say that co-investment opportunities used to be a point of negotiation, but no longer. He notes: “There used to be side letters and all sorts of good stuff.”
To some degree, the opportunity to co-invest can be demanded by LPs who have the advantage of heft. An LP who can commit $100 million for a fund can demand for more rights than, say, an LP who can afford only a tenth of that amount. Larger LPs that have invested beyond a certain threshold in the fund have been known to request and receive preferred rights to a co-investment opportunity or a pro rata share of any co-investment opportunity that exists. The GP, of course, is not obligated to satisfy either request.
When there is an opportunity to co-invest, the GP has the discretion to offer it to any investor, even third parties who are not already LPs in the main fund. These are usually cases where the investor can offer a strategic benefit to the transaction. In some cases, a GP can be inclined to offer the opportunity to all LPs, but this can be an arduous from an administration perspective.

Can't escape Carry

The most attractive feature for a co-investment, from an investor’s perspective, is no or reduced management fees and carried interest, as the GP is already doing the transaction and earning fees through the main fund. If there is a reduction in management fees, it is normally charged on invested, not committed, capital.
“Many co-investment vehicles charge a carry, but this practice varies based on the sponsor: some charge carry, some don’t,” finds Malcolm Nicholls III, a partner at law firm Proskauer Rose in Boston.
“When carry is charged, the carry percentage is usually the same as, or lower than, the amount charged in the main fund. In many cases, sponsors that charge a premium carry of 25 to 30 percent in their main funds will reduce or eliminate the carry in their co-investment funds.”
Clifford Chance’s Glover recounts a conversation with a German investor who is paying carried interest in more than half of the some 40 co-investment deals it is part of. Says Glover: “The historic perception was that getting carry on co-investments was difficult to obtain.
I think private equity fund managers are increasingly asking for carry – they’re providing value and they’re keen to maximize that value by getting some sort of return from it. To the extent to which they don’t have any obligation to provide co-investment opportunities to their investors, then they’re going to potentially look to offer that co-investment opportunity to those people prepared to pay favorable terms for it.”
For some LPs, however, paying carry on a co-investment is all but out of the question. “We believe it’s not our role as investors to pay a promotion fee and carry on co-investments,” says Edouard Tétreau, an investment director in the co-investment team at AXA Private Equity. Tétreau, who has just moved to New York from Paris to expand the firm’s activities in the US, says: “As of today, we’ve never paid a promotion fee on a US co-investment.”
AXA Private Equity, however, may be in the minority of LPs that are in the position to pick and choose from co-investment opportunities.
The firm has a dedicated $750 million fund for co-investments, from which it primarily invests in transactions with an enterprise value of over €500 million ($700 million) in France and Germany, and €150 million in other countries. The firm recently doubled its co-investment team to 12.
According to Glover, there can be a differentiation in fees charged by the type of co-investor brought into a deal in Europe. Management fees or carry is typically not charged for co-investors who fit into one of three profiles. These categories are: another GP who is coming into a deal alongside the lead GP, hence a club deal; a local investor or party who can provide synergistic benefits to the GP, such as political influence or local regulatory knowledge; and an investor willing to buy spare equity quickly.
In the third scenario, fees can be charged on a syndicated deal. Glover says: “What you might see in the third party market is if there’s an excess demand for spare equity, then the private equity house may look to charge some sort of management fee or carry for that opportunity. In my experience, GPs will tend to seek carry ahead of management fees.”
The fourth category of co-investor is probably the most common: the LP who has invested in the fund and is seeking opportunities to co-invest. These are the investors who, in Glover’s experience, most commonly pay management fees or carry.
The unnamed LP says he never pays a management fee or carry for co-investment deals alongside GPs to which the LP already has commitments. If the LP invests in a transaction as a third party, fees can range from no management fee and five percent carry up to 1.5 percent management fee and 20 percent carry.

Pari passu, plus governance
The one place where investors may get to ask for some rights is in the shareholder agreement (or operating agreement in the case of a US limited liability partnership), which is a new partnership agreement created for the co-investment deal. But as the shareholder agreement works off the main fund agreement, there isn’t a lot of room for negotiation.
What investors want in a co-investment deal is pari passu rights equal to the GP. Investors want preemptive subscription rights in the event of follow-on investments by the GP and tag along rights on liquidity events, such as exits. In terms of reporting, LPs may sometimes receive financial statements of the co-investment, albeit unaudited, in addition to regular fund performance reports.
Preferably, investors also want some control rights such as a veto over certain material actions or board representation, but these are hard to come by. The number of investors in a co-investment can determine the amount of control any particular investor can have – usually, the relationship is inversely correlated. In the €5 billion acquisition of TDF, a French infrastructure equipment company, AXA Private Equity was given a seat on the company’s board as the firm was the sole co-investor alongside Texas Pacific Group.
“We don’t necessarily ask for access to governance,” says Tétreau.
“Access to governance is given to us when a sponsor feels we could bring a benefit to the company. Clearly, what we’re not interested in is a less passive co-investment activity where we just sign a shareholder agreement and put it in the hands of the sponsor.”
Tétreau says it is very much in the AXA culture to have a hands-on approach in the types of investments it makes. In one example, the team turned down a co-investment opportunity by a sponsor which refused to give it access to management.
Commonly, LPs are relegated to a minority position in a co-investment, where they receive similar rights as they would in the main fund – despite the additional capital they are putting into that particular transaction.
Voting rights are not important for the unnamed LP, who feels it more important for GPs to keep control of the investment. But the LP would ask for a board observation seat if it invests more than 10 percent of the total equity of the deal.
The shareholder agreement of a co-investment deal is often a streamlined version of the main fund agreement. Comparing the two, Proskauer Rose’s Nicholls says: “Many of the provisions [in the co-investment vehicle] are eliminated or tied back to the main fund agreement. For example, portfolio or geographical diversification restrictions
simply won’t apply so they will be deleted. Furthermore, if the deal will generate UBTI [unrelated business taxable income] or ECI [effectively connected income], then it will be structured accordingly and restrictions on these issues will be removed. Finally the key person and no fault provisions usually are simplified to occur upon such events occurring in the main fund.”
In the venture capital world, terms and conditions for co-investments are entirely different, and much more LP-friendly. Says the unnamed LP: “My partners [who do venture capital co-investing] are taking larger pieces of deals, even leading some rounds. They almost always have board seats, they share the work and the economics.
The venture business has stayed collegial. No one likes to write too big a check on any one deal and they’re used to clubbing together.”
In the competitive buyout world, co-investing for an investor means putting a lot of faith and trust in the GPs if the opportunity rolls around. Investors may negotiate for terms from a regulatory perspective that they need for the deal, but if the opportunity is being offered to a number of investors, the GP may be disinclined to get tied up in negotiations with particular investors if it means slowing down and risking losing the deal.

In Europe
Co-investments in Europe are beginning to take on the structures similar to deals in the US, where a separate vehicle is created specific for the transaction. The change has been taking place over the past two to three years and is the result of changes brought about by MiFID.
Glover says: “The MiFID regime places quite a lot of regulatory capital burdens on entities conducting investment management activities, but there is an exemption for entities who are operating a collective investment scheme.” Thus co-investments in countries that fall under the umbrella of the European Commission are typically structured as English limited partnerships.
The separate vehicle structure for a co-investment is already common in the US. These structures benefit the GP, who can control the vehicle and the underlying investment. It also helps that the GP only has to deal with a few vehicles, rather than numerous co-investors individually.
“Although it is unusual for a sponsor to permit an investor to coinvest directly in the portfolio company, rather than through a vehicle established by the sponsor, occasionally this is permitted,” says Nicholls. “In these cases, sometimes the sponsor will execute contractual arrangement with the co-investor that governs the fee to be charged, if any, as well as the control over voting rights.”
Although the relationship in a co-investment may be imbalanced in favor of the GP, it is still a relationship that should serve the interests of both parties. And if equity becomes even more precious in the wake of the credit crunch, LPs may find their capital to be something GPs are willing to negotiate for.