The New Co-Investment Landscape: What You Need to Know. October 13, 2015

Transcription

1 The New Co-Investment Landscape: What You Need to Know October 13, 2015

2 What Are Co-Investments? Co-Investments are opportunities to invest alongside one or more of a sponsor s primary funds Such opportunities typically arise because the size of the investment is too large for the primary fund due to: diversification restrictions contained in the fund agreements the sponsor s own determination of appropriate concentration risk regulatory limitations applicable to the investment (e.g., Bank Holding Company Act, Media Insulation Rules, etc.) In private equity, co-investment opportunities are almost always allocated only to investors who are invested in the sponsor s primary fund: Larger investors may negotiate side-letter provisions entitling them to a pro rata share of co-investment opportunities Some private equity fund agreements will give all, or a subset of, investors coinvestment rights In hedge funds, a pre-existing investment with the sponsor is not always a prerequisite. While it is not technically a co-investment, sponsors may offer one-off investment opportunities that are not suitable for their primary fund(s): This is becoming increasingly more common in hedge funds, especially illiquid/lessliquid opportunities:

3 ANNUAL NEW YORK PRIVATE INVESTMENT FUNDS CONFERENCE 2015 Trends & Developments Traditionally, such investment might have been done through a sidepocket

4 Trends in Co-Investment There has been an increase in investor interest in co-investments over the past several years This increased interest spans all assets from traditional private equity to real assets and liquid investments There are several reasons that investors are attracted to co-investment opportunities, including: exposure to direct investments and specific industries greater transparency and more direct control over investments learning experience in particular industries potential for higher returns (with lower fees) diversification of investors portfolios Fund of fund managers represent the investors most interested in co-investment, and many have established dedicated co-investment products to leverage co-investment opportunities obtained through their existing primary fund investment relationships:

5 ANNUAL NEW YORK PRIVATE INVESTMENT FUNDS CONFERENCE 2015 Trends & Developments Approximately 73 percent of fund of fund managers expressed an interest in coinvestment 1 Investors interested in co-investment opportunities span the globe: While almost half of the investors interested in co-investment opportunities are based in North America, investors based in Europe make up almost a quarter of the investors interested in such opportunities; the rest of investors are based around the world 2 1 Source: Fund of Funds Managers Interested in Co-Investments, Preqin Investor Intelligence, Private Equity Spotlight, March Source: Edwards, Katie. Investor Appetite for Private Equity Co-Investments, Web blog post. Preqin 10 Apr Web 28 Sept

6 How Are Co-Investments Structured? A. Private Equity Funds: Single-asset vehicles: Single-asset vehicles represent the most common approach in structuring private equity co-investment The sponsor will set up a dedicated investment vehicle for each co-investment opportunity to invest alongside the primary fund(s) The co-investment opportunity is usually offered to investors in parallel with coordinating the investment of the primary fund(s) Dedicated co-investment vehicles: Dedicated co-investment vehicles are established at the same time the primary fund is raised to invest alongside the primary fund in all investments where there is excess capacity, and they can be established for multiple investors or a single investor: Sometimes, sponsors may limit access to the dedicated co-investment vehicle to larger investors The vehicles may be structured to be entitled to a fixed percentage of each primary fund investment, or allocations may be at the sponsor s discretion Dedicated co-investment vehicles exist in two primary formats:

7 ANNUAL NEW YORK PRIVATE INVESTMENT FUNDS CONFERENCE 2015 Trends & Developments Committed vehicles : In committed co-investment vehicles, investors make an up-front commitment and invest in co-investments on a blind pool basis They are often used as means to offer fee discounts to larger/important investors Opt-out vehicles : In an opt-out co-investment vehicle, investors can pick and choose the deals in which to participate Investors are given notice of the opportunity and have a specified time period in which to opt-out; otherwise, they are deemed to have elected to participate These vehicles also exist in an opt-in format, but follow the same principles B. Hedge Funds: Like private equity, hedge funds also use single-asset vehicles In light of the nature of the assets (often listed securities), managed accounts are also a very common structure Many investors prefer this structure due to the transparency afforded by having custody over the assets The use of dedicated co-investment vehicles/side cars is more common than in private equity Many hedge fund sponsors have embraced the use of Delaware multi-series partnerships or Cayman Islands segregated portfolio companies for their co-investment structures: These types of vehicles provide flexibility and can be used in lieu of setting up separate vehicles for each transaction Each co-investment is made through the same vehicle, but through a separate class of interest/portfolio These vehicles can provide for statutory ring-fencing between investments to avoid cross-class liability so that investors in one co-investment do not bear risk of loss from other co-investments in which they do not participate These vehicles can be difficult to administer, and not all jurisdictions will recognize the ring-fencing between classes/portfolios Private equity has not embraced the use of these structures, and it traditionally approximates ring-fencing through the use of special purpose vehicles below the coinvestment fund to hold each investment

8 Fees Management fees, carried interest and performance allocations charged by sponsors in connection with co-investment are almost always discounted to those of the primary funds It is not unusual to see no management fee charged along with a reduced carried interest/performance allocation: In private equity, it is not unusual to see no fee or carried interest For committed co-investment vehicles, performance will typically be netted across investments for purposes of calculating the carried interest/performance allocation For opt-out vehicles, carried interest/performance allocation is usually calculated on a deal-by-deal basis with no netting

9 Liquidity For private equity co-investments, the terms of the primary fund will typically dictate that all co-investments be purchased and sold at the same time, and on the same terms as the primary fund: This is typically not an issue, given the nature of the investments and expectation of a closed-end structure For hedge fund co-investment, the sponsor will typically seek to structure the liquidity profile of a co-investment to match the liquidity profile of the other funds and accounts investing in the asset in question: However, co-investors may often seek different liquidity, which can present conflict of interest and regulatory issues Since many hedge fund co-investment opportunities are illiquid/less-liquid investments, many are structured as closed-end vehicles or vehicles with long lockup periods In some cases, these closed-end type vehicles contain target harvest periods with varying economics to the extent that the targets are not met

10 Sponsor Challenges with Co-Investments When offering co-investment on a deal-by-deal basis, sponsors have to conduct an offering process while simultaneously negotiating the underlying investment, creating additional work streams and issues, including: Offering of the co-investment opportunity: Preparing co-investment disclosure documents Preparing and negotiating co-investment agreements with investors Facilitating investor due diligence Confidentiality: Sponsors may need a separate non-disclosure agreement with investors for the co-investment, which may need to include the co-investment target as a party Warehousing/syndication: Given timing considerations, it may not be possible to simultaneously close on the primary fund investment and co-investment Having the main fund warehouse the whole transaction and later syndicate to coinvestors is a possibility, but it presents a variety of conflict of interest and regulatory issues due to valuation fluctuations during the warehouse period. Furthermore, to the extent that there is significant loss of value, there may be an overallocation of the investment opportunity

11 Compliance and Regulatory Concerns A. Compliance Challenges: Syndication can pose several risks: Confidentiality and material nonpublic information concerns: Sharing investment ideas may be seen as material nonpublic information Sections 13 and 16 concerns arise when there is an agreement related to the voting or disposition of a registered class, which could result in the creation of a group Under Section 13: Ownership for Section 13 purposes is based on the group s total stake, and reporting of assets and purchases of the group and each party is required if the group exceeds 5% Under Section 16: This is a separate reporting regime (Forms 3 and 4), but, more importantly, it subjects each co-investor member of the group to the short-swing profit rules if the group owns more than 10% Poison pill and change of control provisions: These are frequently drafted to be triggered by group formation Broker-dealer concerns: With respect to any co-investments offered, the sponsor may not receive a commission or other transaction-based fee in connection with the sale of a coinvestment to a co-investor

12 ANNUAL NEW YORK PRIVATE INVESTMENT FUNDS CONFERENCE 2015 Trends & Developments Other compliance challenges include: developing and tracking co-investment allocation policies tracking and incorporating all co-investment rights and terms from side letters and other contractual agreements with the primary fund(s) and investors determining expense allocations among primary fund(s) and co-investors disclosing co-investment policies to investors Sponsors should also consider investor relations concerns when offering co-investment opportunities to investors B. Regulatory Concerns: Recent Securities and Exchange Commission speeches and cases, as well as examination priorities, have indicated that co-investments, and the conflicts of interest posed by them, are one of the Office of Compliance Inspections and Examinations priorities: In particular, regulators have focused on disclosure of a sponsor s co-investment policies and whether the governing documents and disclosure documents address co-investments: Do the primary fund documents, Form ADV disclosures, and sponsor s policies and procedures adequately disclose co-investment opportunities, as well as the conflicts of interest that may arise from them? Are investors aware that a sponsor may be offering co-investment opportunities preferentially to select investors? Recent speeches include Marc Wyatt, Acting Director, Office of Compliance Inspections and Examinations, Speech: Private Equity: A Look Back and a Glimpse Ahead, Private Equity International (PEI) Private Fund Compliance Forum 2015 (May 13, 2015) and Andrew J. Bowden, Director, Office of Compliance Inspections and Examinations, Speech: Spreading Sunshine in Private Equity, PEI Private Fund Compliance Forum 2014 (May 6, 2014) Recent broken-deal expense case: In the Matter of Kohlberg Kravis Roberts & Co. L.P., Release IA-4131 (Jun. 29, 2015) Co-investments raise numerous fiduciary duties concerns and conflicts of interest, including: preferential treatment of certain investors allocation of limited investment opportunities (including follow-on investments) among primary funds and investors allocation of expenses (including broken-deal expenses) and fees liquidity terms (as noted above) timing and manner of dispositions

13 Speakers: Barbara Niederkofler, Partner / Fadi G. Samman, Partner