Co-investment transactions have become increasingly popular as investors search for yield. Unlike club and consortium deals among private equity sponsors, or even between private equity firms and strategic partners, in which the terms of the arrangements have become increasingly standardized, co-investment transactions come in many different shades, depending on the equity splits between a lead sponsor and the co-investors (who typically hold in the aggregate 10-25 percent), the identity of the co-investors (e.g., limited partners of a lead sponsor, other private equity firms with different profiles, or even strategic investors), and a variety of other factors including deal origination, sector expertise and the jurisdictions of the co-investors.
Co-investment transactions serve a number of important purposes for their participants. For lead sponsors, co-investors can help plug holes created by tight debt markets, reduce risk exposure, and/or bring additional industry or regional expertise or simply a brand-name to an investment. They can also serve as an important tool to build and cement a lead investor’s relationships with third parties, particularly with a sponsor’s limited partners. For co-investors, these opportunities offer diversification, a chance to achieve better net investment returns and the acceleration of capital deployment. They also can help deepen institutional relationships and give the co-investor the opportunity to piggy-back of the insight and expertise of the lead investor.
But, while co-investments offer their participants these various benefits, they also present some unique challenges for deal participants, as each is bespoke, and there is no one-size-fits-all template for the governance arrangements in these transactions. Opportunities for creative structuring abound. This article discusses some important process matters and common issues that arise in these types of deals, and identifies typical negotiating positions of sponsors and co-investors on these issues.
It is in the interests of both lead sponsors and prospective co-investors to consider carefully and clearly communicate their expectations for a co-investment opportunity before any definitive documentation is produced. Initial discussions of the proposed structure of a co-investment often represent a good early opportunity for sponsors and prospective co-investors to determine how their expectations are aligned.
A sponsor typically sets up co-investment programs on a deal-by-deal basis. Depending on the size of the investment and anticipated number of co-investors, a sponsor may be more or less flexible in accommodating structuring or other requests from individual co-investors. The potential iterations that a sponsor may choose from are varied, e.g., a single sponsor-controlled limited partnership that will invest in the sponsor’s acquisition vehicle, a series of sponsor-controlled limited partnerships each holding the interests of individual co-investors, direct investment by co-investors into a sponsor’s acquisition vehicle or some combination of the above. From a sponsor’s perspective, the structuring of a co-investment is important to enable it to dictate the “rules of engagement” for co-investors and manage expectations of the respective roles of the sponsor and co-investors in the governance of the investment.
From a co-investor’s perspective, while it cannot (except in highly unusual circumstances) dictate structure, it should review any proposed structure to make a judgment promptly as to whether it meets the co investor’s tax needs (an important threshold question) and whether it is likely to meet its expectations in terms of minority investor protections, post-closing funding obligations and exit options. Co-investors may also want to consider a sponsor’s ability to change the structure in the future, and whether such changes would be acceptable (e.g., continue to meet the co-investor’s tax needs).
Diligence and Documentation: Trust, but Verify
In a typical co-investment process, co-investors do not have the opportunity to (or may not want to devote the resources to) conduct their own fulsome due diligence on an acquisition target and instead must (or may choose to) rely on the sponsor’s diligence. Co-investors considering an equity co-investment or syndication will typically, though not invariably, wish to review the lead investor’s formal diligence materials (e.g., professional advisors’ reports), and also have the opportunity to evaluate the sponsor’s experience with, and approach to, the diligence process, so that co-investors are able to get comfortable not simply with the findings of the diligence, but also with the manner in which it was conducted. To the extent a co-investor has particular diligence needs, such as in the areas of tax or corporate social responsibility, it should raise these issues as early as possible with the lead sponsor so the parties can decide if additional diligence is warranted.
Similarly, unlike many club and consortium deals, co-investors in deals of this type rarely have any direct involvement in, or control over, the underlying M&A deal subject to the investment, as it is often important to the sponsor’s underlying M&A deal that any such co-investor involvement in fact be very limited. Co-investors are well-advised, of course, to review all of the deal documents to ensure that any structuring issues of the kind discussed above are properly addressed, to understand the financial arrangements and key risk allocations in the deal and to identify any elements of the deal arrangements that may affect their interests uniquely. They also sometimes strategize with the lead investor, but are not directly involved with the negotiations or the preparation of the underlying deal documents. As with the diligence process, a trust but verify orientation is the norm here.
The Investor Arrangements: Maintaining Alignment
Lead sponsors believe, with reasonable justification, that they will ultimately bear responsibility for the success (or failure) of the underlying acquisition. Accordingly, most sponsors do not concede governance rights to co-investors that would inhibit the sponsor’s ability to take the kinds of actions that it deems necessary or appropriate to maximize the value of the investment.
While approaches vary widely, our clients, both on the co-investor and sponsor sides, often find the most efficient and mutually acceptable means to ensure sufficient minority protections for co-investors is not through a cumbersome negotiation of an extensive or detailed list of co-investor “veto rights,” but rather by seeking to maximize the alignment of interests between sponsors and co-investors and developing a set of parameters in the principal equity deal documents that allow sponsors sufficient control to manage the investment as they see fit, while also protecting the economic interests of co-investors from disproportionate value erosion due to unilateral sponsor actions (intended or unintended). In this regard, the following provisions are typically negotiated in transactions of this type.
- Pari Passu and No Fee/No Carry Investment. To keep sponsor and co-investor economic incentives as aligned as possible from the outset of the transaction, co-investors typically seek to invest (directly or indirectly) in the same type and mix of securities as the sponsor on a no-fee (or very low fee)/no-carry basis.
- Anti-Dilution. Also to maintain economic alignment, co-investors often seek reasonable minority investor consent rights (usually on the basis of a majority of the securities held by all co-investors) with respect to new issuances of equity or debt securities and/or a pre-emptive rights in connection with such new issuances (subject to possible carve-outs for pre-approved syndications by the sponsor, issuances in distress situations, issuances in connection with acquisitions or joint ventures and other typical exemptions). Many lead sponsors are unwilling to grant any kind of investor consent or preemptive rights with respect to debt instruments, as sponsors view that piece of the capital structure to be fully within their domain. In any event, co-investors should take into account tactical considerations if they have to choose between consent rights and pre-emptive rights. While preemptive rights can provide protection against dilution, they are of little value to a co-investor who does not wish or otherwise have the capacity to invest additional funds into the investment platform in question.
- Amendments to the Terms of the Equity Documents. Documents such as the main shareholders, partnership or LLC agreement and the related constituent documents of the co-investor vehicle set out the legal basis for the essential economic agreement to which all parties agree at the time of the investment. Co-investors are, therefore, likely to take the position that a sponsor should not be able to alter those agreements without co-investor input (again, typically on the basis of a majority of the securities held by all co-investors). A sponsor will typically seek carve-outs to such restrictions to the extent any alteration does not materially or, alternatively, materially and disproportionately, impact co-investors (sometimes as compared to the lead sponsor only) and other carve-outs that allow it to implement other specific transactions otherwise permitted by the co-investor agreements, such as raising distressed capital, taking a target public or effecting a sale or liquidation of the target.
- Affiliate Transactions. Co-investors often worry that affiliate transactions can represent an open “back-door” opportunity for sponsors to extract value from the target without sharing it with co-investors, whether it is through preferential consulting or management arrangements, lending, transactions between the underlying target, on the one hand, and a separate entity owned by the lead sponsor, on the other hand, or by other means. Accordingly, broadly speaking, co-investors often take the position that all affiliate transactions should be subject to minority consent (again, typically on the basis of a majority of the securities held by all co-investors). Many lead investors are quite resistant to any such restrictions, however, whereas others may consider accepting such a limitation subject to carve-outs for pre-agreed consulting arrangements, transactions conducted in the ordinary course of business, consistent with past practice, or transactions on arms’-length terms (established in a variety of different ways on a deal-by-deal basis).
- Creating Exit Incentives. Co-investors will typically have little, if any, control over exit opportunities, but will seek to maintain economic alignment by including low-threshold or no-threshold tag-along rights and piggy-back rights in the investor agreement. Conversely, lead sponsors will also seek low-threshold or no-threshold drag-along rights, IPO rights and other orderly sale provisions in their favor. Exit provisions typically also stipulate the type(s) and mix of consideration acceptable to co-investors as well as negotiated limitations on warranties, indemnities and exit cost-sharing. Lead investors and co-investors sometimes have differing views as to what type of exit event should lead to the termination of the rights of the co-investors under the governance arrangements, with sponsors typically seeking earlier sunset triggers (e.g., any IPO of any kind) and co-investors often wanting to preserve their negotiated investor rights (or at least a sub-set of them) until a more complete exit by the sponsor.
- Most Favored Nation. In a co-investment that is structured as a sponsor-controlled limited partnership, co-investors often have more circumscribed options to maintain alignment with the sponsor. Co-investors in such an indirect structure can still seek to achieve the same kinds of controls outlined in the bullets above, albeit this is generally through limited partner consents for certain actions to be taken by the general partner. But, because a limited partnership agreement can be modified by individual side letters between the general partner and specific limited partners that may not be known to other limited partners (in contrast to a shareholders agreement, which is typically visible to all shareholders), one of the key provisions to ensure desirable and predictable outcomes of negotiations on fundamental governance and economic points is a “Most Favored Nation” clause. As with structuring, the type of MFN agreed upon can have a significant impact on outcomes. Some sponsors favor a “commitment based” approach (i.e., the rights offered to co-investors vary based on the level of their commitment) similar to what one might use in raising a main private equity fund. Co-investors tend to prefer a “rights-based” approach (i.e., any preferential rights offered to one co-investor must be offered to other co-investors who have negotiated an MFN clause), though depending on appetite for control and maintaining the limited liability status, co-investors may agree to limit their MFN to rights impacting economics or other issues of particular import to them.
- Expenses. Although rare, and frequently resisted by lead sponsors, some co-investors invoke the alignment of economic interests principle to seek reimbursement of expenses incurred in connection with the initial investment, add-on investments and/or exit transactions to the same extent the sponsor’s expenses are reimbursed, or alternatively, agreement that each party bear its own expenses.
- Reporting Obligations. A co-investor also typically ensures that it has information rights to allow it to (1) meet its tax filing requirements, (2) monitor its investment and (3) distribute information about the target’s performance impacting the co-investor’s investment to its own investors (which may require exceptions to confidentiality provisions in the governing documents).
Note also that sponsors and their advisors should carefully assess corporate law minority protections, which will vary based on entity type and jurisdiction, as these may afford co-investors greater power at critical junctures than the parties generally contemplate in the deal documents, e.g., through per capita voting procedures or supermajority voting requirements.
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Given the varying shades of these types of co-investment deals, the tactical approach to negotiations of them can be as important as the inherent negotiating leverage and substantive precedents of the various parties. This is particularly true given the typical negotiating dynamic, in which the relationships between a sponsor and co-investors are usually multi-dimensional and not limited to simply a one-off co-investment transaction and each co-investor negotiates the co-investor related arrangements with the lead sponsor separately.