Research

Offering co-investment opportunities to certain fund investors is a key trend for fund sponsors in establishing alternative investment funds.

Once an optional sweetener, today’s large institutional investors expect to benefit from co-investment rights – primarily to enhance returns through lower fee arrangements, but also to gain increased exposure to specific assets and, for some, to gain experience in a more direct form of investment while building stronger relationships with sponsors.

However, the benefits of co-investments do not solely fall to investors. Sponsors may also benefit from fund investors co-investing in particular investments, especially where the fund would not otherwise be able to make the investment – for example, due to investment restrictions in the fund documentation which impose a maximum exposure of the fund to a particular type of asset, geography, leverage etc. – or where the sponsor determines that the fund should not or cannot acquire the whole investment for diversification reasons or other reasons.

Who gets what?

The perennial issues for both fund sponsors and investors involve who gets what:

Identifying co-investors

Who is offered co-investment rights varies between funds and sponsors. Some sponsors are quick to offer co-investment rights to those investors who ask for them. Others require a certain level of investment in the main fund to unlock access to co-investment rights, or only grant co-investment rights to investors who invest in the fund at first close. In our experience, it is uncommon for co-investment rights to be offered on a pro-rata basis to all investors. Sponsors have tended not to offer rights to those investors who do not request them, and offering co-investment opportunities pro-rata to all investors can be cumbersome and difficult to manage. Rather, sponsors prefer to retain discretion to offer the opportunity to co-invest in a particular asset to investors who they determine to be “strategic” investors, whether due to such investor’s experience in investing in the relevant asset class, its relationships in the industry, the amount of capital the investor has committed to the main fund or otherwise.

Co-investment opportunities may also be offered to third party investors, who have not invested in the main fund. There has been an increase in the number of sponsors establishing pure co-investment funds. Typically these co-investment structures are fund of funds models, which invest in co-investment opportunities offered by other sponsors, without a requirement for the fund of funds to invest in the underlying main fund. Co-investment funds tend to have a longer term and lower fee structure compared to traditional alternative investment funds, reflecting the underlying asset class as well as fee rebates negotiated by the sponsor with underlying sponsors, and may be an attractive option for investors with limited in-house co-investment execution ability.

Particular co-investment rights to offer

The co-investment "rights" offered differ markedly between sponsors. Some sponsors provide a simple acknowledgment of an investor’s interest to participate in co-investment opportunities, generally by way of side letter. From a sponsor’s perspective, this allows sponsors complete discretion and flexibility in allocating co-investments, and affords them the right to determine who they consider to be the most appropriate or desirable co-investor for any particular deal. In making such determination, sponsors may take into account factors such as the type of investment, the funding requirements, any impact of the involvement of a co-investor on a particular deal (favourable or otherwise), their relationship with a particular investor and whether or not they think that an investor can mobilise funding and act quickly in implementing a co-investment. While many investors require co-investment rights as part of their due diligence process to invest in alternative funds, in our experience a significant number of them are unable to actually implement such rights when the time comes. Often investors become stymied by internal processes – approvals, lead times for funding etc. – or lack the relevant experience to be able to get the deal done in time. Sponsors value co-investors who are able to rapidly assess the relevant co-investment opportunity, respond quickly and provide funding within a short time frame.

By contrast, some investors demand more certainty and request access to a specific level of co-investment opportunities and for a detailed co-investment allocation process to be followed. Some request pre-emption rights over all co-investments of the fund, and require comfort that existing investors will be offered the right to co-invest in any particular asset before such asset is offered more broadly to third party co-investors. Sponsors must balance their need for a successful fundraise with their ability to implement any agreed co-investment rights and processes. Many are keen to ensure that they do not become too restricted by prescriptive rights and processes which turn out to be unworkable if they are offered to too many investors.

For the moment, there is no “one size fits all” approach to co-investment in the private funds industry and ultimately it is all a matter of negotiation.

In the US, the SEC is focusing on co-investment allocations in the context of disclosure, highlighting in particular that priority co-investment rights granted to particular investors should be disclosed to other investors due to the potential for conflicts of interest to arise. Asian sponsors fundraising in the US market should be mindful of this in granting co-investment rights and allocating co-investment opportunities to their investors, and particularly in light of the way in which their “most favoured nations” arrangements (if any) may be structured.

Potential conflicts of interest

At an investor-relations level, sponsors who have offered specific co-investment rights to investors are keen to actually provide co-investment opportunities to such investors. Sponsors need to ensure that in promising co-investment rights to investors as part of their fundraising negotiations they can actually deliver on such rights, taking into account any co-investment rights offered to other investors, and most importantly, bearing in mind their duties to the fund.

The potential for conflicts of interest may arise in the context of co-investments, as the sponsor generally has a fiduciary obligation to act in the best interests of its investors. For co-investment opportunities that arise because the fund is prevented from making the investment on its own due to its investment restrictions, this does not typically pose an issue. However, when a sponsor is considering an investment which the fund could, in accordance with its constituent documentation, undertake on its own without co-investment, the potential for conflicts of interest becomes more pronounced. This is also the case where the sponsor has established a separate co-investment fund to invest alongside the main fund, as the sponsor will generally owe fiduciary duties to both its fund investors and its co-investment fund investors. It is in circumstances such as these that having, and following, a robust co-investment protocol is important to help navigate any potential conflicts and provide a more independent procedure for investment allocation.

Co-investment protocols usually sit alongside the sponsor’s conflicts of interest and allocations policies and should govern the way in which the sponsor allocates investment opportunities between funds and co-investors, including in the situation where the sponsor has multiple funds with similar investment strategies in the market. Whether a protocol assists in managing any potential conflicts of interest in allocating co-investments will depend on the level of detail contained within such protocol, and, most importantly, how it is valued by the sponsor. To be effective, the protocol must be adhered to, and regularly reviewed and updated. Investors often ask for copies of such protocols and notifications of any changes. Another way in which conflicts of interest such as these may be managed is through the investor advisory committee approval process.

Standard co-investment terms?

In Asia, as yet there are no standard terms for co-investment rights in the private funds industry, other than that fees for co-investments are typically lower than those in the main fund. Fees can range from “no fee/no carry” models, through to arrangements which charge both management fee and carry and may differ between investors (subject to any MFN rights). Fee arrangements will generally also be higher on co-investments if the sponsor is managing the co-investment, and/or any pooled co-investment vehicle, for the investors. Where a separate pooled co-investment vehicle is established to make co-investments, the terms and conditions of that vehicle may differ markedly from the main fund terms, reflecting a more active investor base and usually a more “club”-style approach.

Passive investors will often request that co-investments be made on the same terms and conditions as the investment made by the fund in the particular asset, and be acquired and disposed of at the same time, subject to any particular regulatory or tax considerations. However, active co-investors may have different investment horizons, financing and structuring preferences and strategic objectives, and may require bespoke co-investment terms. Sponsor must seek to balance and manage differing priorities and competing interests in respect of each co-investment opportunity.

With regulators focusing globally on increased transparency and disclosure, we anticipate that more market-standard terms will emerge in coming years in relation to the offering of co-investment rights by private sponsors.

Suzanne Gibson is a special counsel in the Singapore office of King & Wood Mallesons. Suzanne is Australian and English law qualified and has 19 years’ experience in funds and real asset transactions. Suzanne advises fund managers on fund establishment and related asset management issues and has particular experience in the establishment of global real estate and infrastructure funds. Suzanne acts for investors in funds, including private equity and alternative funds, and on funds secondaries transactions. Suzanne provides advice to financial institutions in relation to global regulatory change, including FATCA, the OECD Common Reporting Standard and the European Alternative Investment Fund Managers Directive.

Chi Ha is a Vietnamese native speaker and an Australian law qualified lawyer in the Singapore office of King & Wood Mallesons. She has extensive experience in the structuring of and advising on major cross-border investments in Asia and is currently advising on a number of fund establishment and investment transactions. Chi started out as a tax lawyer in Melbourne and spent the last 5 years working as a corporate and funds specialist on major transactions on the ground in Vietnam and Singapore.

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