Private Equity News - Who Gets To Share? The Opaque World of Co-investments
By Yolanda Bobeldijk
May 2, 2016
Choosing who to share with can sometimes be tricky. Private equity firms that frequently have to choose which investors will get the opportunity to invest in potentially lucrative deals alongside them are finding their decision-making process is being scrutinised.
Until now, how buyout firms divvy up co-investments – where investors invest alongside buyout firms on a deal and typically avoid fund fees – has remained largely a mystery.
The problem for investors is that when they commit to a fund, they often don’t know if they will receive any co-investment opportunities or how many. While co-investment deals have become a common part of private equity dealmaking, there is no standardised industry policy on how these investments are allocated. While the decision lies with the manager, investors and regulators want to know the process is fair.
Many managers pick their co-investment partner as they go along, some opt for a rotation system, while others have a "pro rata" system where they divide them up equally. Some managers have a separate co-investment vehicle that invests alongside their buyout fund.
One investor relations executive at a U.K. mid-market firm said: "Everyone is doing it in different ways. I have [even] heard [of firms] showing everything to everyone, which seems really time consuming to me."
Another investor relations professional at a large U.K. buyout house said: "We are doing this slightly more on an ad-hoc basis. We don’t have hundreds of investors, but only around 70. Only a sub-section of those investors have interest in co-investments and only a handful [of investors] are able to make the time frame, so we don’t have to be very formalised about it."
A head of investor relations at a London-based Europe-focused firm said that it only offers co-investments to the largest 10 investors in its fund. "Among the 10 investors we rotate. It also depends on the size. If someone did the last co-investment we wouldn’t ask them next time. Say we have €50 million in co-investments. We would reach out to seven [investors]. Usually two of them won’t be able to do it and we would end up dividing the €50 million among the five investors."
He said that its smaller investors are not included and added that dividing it up pro rata is "unmanageable".
The investor relations executive at the U.K. mid-market fund said at his firm the investor relations team asks investors during each fundraising about their co-investment appetite and re-checks this half way through the fund. "We ask the people that are interested further questions: what sectors [do they want to invest in] and which geographies, how quickly they can move [and] what their ticket size is. That works pretty well."
Many investor relations professionals point out that splitting the co-investment piece equally doesn’t work because the piece will become so small per investor that it’s not worth their time, effort and money.
Christiian Marriot, fundraising and investor relations partner at Equistone, said: "We don’t divide it up pro rata because the capital we syndicate would typically be between €10 million and €20 million. If you divide that up between all your LPs it becomes meaningless. It is mathematically possible but not in anyone’s interest."
However, many investors are trying to negotiate preferential terms on co-investments during fundraising talks. And these co-investment agreements are often taking centre stage. At the annual SuperReturn conference in Berlin in February, Richard Howell, a partner at Paris-based PAI Partners, said it was "scary" when investors paid more attention to co-investment allocations than to fund performance when doing due diligence on a fund.
The head of IR at the Europe-focused firm added: "As we are in fundraising, we have larger investors coming to us and saying that they will make a fund commitment if they can negotiate co-investment rights. We say no to that, because you might satisfy one large [investor], but you will [annoy] 10 others."
This sentiment is echoed by a London-based managing director at a global buyout firm. "We get a lot of pressure from [investors] for co-investments. If investors say, we can’t come into your fund unless you give me X in co-investment, we resist."
Yet in reality, larger investors are often granted sweetheart deals, according to Alexander Apponyi, European head of Jefferies Private Capital Group. "Many [investors] will have negotiated preferential side letters or [have] been offered preferential terms. This will allow [firms] the ability to give certain investors a heads up before contacting their other investors so they will be the only ones that can make the timeframe," he said.
Merrick McKay, a managing director at Edinburgh-based SL Capital Partners, said: "We are invested with one [firm] who has one very large investor. That investor can only write very large co-investment tickets. When the [firm] had a large co-investment piece it was offered to that larger [investor] which is understandable."
However, investors are often unaware of the co-investment agreements that their competitors have sealed. Some funds have a "most favoured nation" clause, which means there needs to be disclosure of deals between the fund manager and individual investors.
However, this is not always the case and if there is such a clause, it’s often not very detailed. That means that if a large sovereign wealth fund has agreed to see all co-investment deals ahead of other investors, it would be sufficient for the fund documentation to state that "certain investors have arranged certain rights".
What’s more, the most favoured nation clause has become more complicated – with fund managers adding different tiers for different investors. Mr. McKay said: "People that have invested between a certain range have the same rights, and investors that have invested less will be in a lower tier with different rights."
The most favoured nation clause also often excludes co-investment rights. Fund lawyers working on behalf of private equity firms are advising them to keep their co-investment cards close to their chest. One European fund lawyer said: "Currently there are lots of exceptions to the most favoured nation clause and that includes co-investments."
Side letters are opaque and there’s not much in it. "It’s more like a handshake. One [investor] will say, I expect to see co-investments [when I commit to this fund] and everyone knows what’s expected. I always advise [firms] to have maximum discretion."
This is also something that the U.S. regulator, the Securities and Exchange Commission, is increasingly concerned about. Marc Wyatt, acting director, Office of Compliance Inspections and Examinations, said in a speech in May 2015 – which has been published on the SEC’s website – that the SEC had "detected several instances where investors in a fund were not aware that another investor negotiated priority co-investment rights".
He added: "Disclosing this information is important because co-investment opportunities have a very real and tangible economic value but also can be a source of various conflicts of interest."
Mr. Wyatt said many in the industry have responded by disclosing less about co-investment allocation rather than more because they assume that if a fund manager does not promise its investors anything, it cannot be held to account. He said the risk with this approach "is that such promises are often made anyway, either orally or through email. I believe that the best way to avoid this risk is to have a robust and detailed co-investment allocation policy which is shared with all investors".
However, some firms are offering co-investments as a way to differentiate themselves from competitors. Or they use it as a carrot during fundraising by offering free deals to investors that commit to the fund early. Mr. Apponyi said: "The SEC is concerned about equality and is intervening in stapled co-investments as part of a primary fundraising. What could be used to entice [investors] previously is no longer possible now."
Yet some IR professionals are not in favour of using free deals to lure investors. The IR executive at the U.K. mid-market firm said: "Some people offer co-investments as an early bird discount. But if a sovereign wealth fund comes in at the final close and demands the same terms and is granted those, then you have been selling under false pretences."
He said his firm discloses all co-investments in its quarterly reports. "Don’t agree to things that may look dodgy. If you conceal it you are being dishonest."
Mr. Marriot agreed. "Co-investment agreements are carved out of our [most favoured nation] clause so we have full discretion about our co-investments. However, that doesn’t mean you don’t have to be transparent. In our quarterly report we disclose all shareholders for each investment, including our [investor] co-investors."
As the regulator has taken an interest, private equity firms have become much more careful. Peter Martenson, partner and head of global distribution at placement agent Eaton Partners, said: "My experience is that where there are larger [investors] who have [certain] terms, [firms] make it very clear to other [investors]. [Firms] do not want to be caught sideways."
The head of IR at the European-focused firm agreed. "We are documenting our process much more thoroughly because the regulators have expressed an interest in this."
While many agree that disclosure is important, many also point out that it is hard to formalise a co-investment strategy. Mr. Marriott said: "It’s not a perfect science. It is not our experience that [firms] only give co-investments to their largest investors. We did a co-investment in 2012 with an [investor] that was one of the smaller investors in the fund. But they could act quickly on this deal and had a specific sector angle that was beneficial to the deal. We aim to pick the best partner for the deal."
A one-size-fits-all approach is impossible, said Mr. McKay. "This is not a box-ticking exercise because situations and deals differ. It doesn’t surprise me that people use different ways of dividing up co-investments. I can’t see how you can put a regulatory or legal straightjacket on it. Ultimately you have to rely on the [firm] being fair."