Complications in Co-Investments

In the middle market’s crowded private equity fundraising environment, even firms with good track records sometimes struggle to entice investment dollars, and general partners (GPs) are more apt than ever to negotiate with limited partners (LPs) to sweeten the deal.

Specifically, GPs are increasingly likely to offer — and LPs are increasingly likely to ask for — co-investment opportunities.  Co-investments provide an LP (or a third-party investor) the option to take part in a private equity project, only this time at lower round-trip costs and without the limiting fund structure.

When they function correctly, co-investments are a wonderful and effective tool. GPs can expand platform and portfolio development, LPs assume greater control and realize greater returns, and everyone can generate a higher deal flow.

Unfortunately, co-investments don’t always function correctly. Even among seemingly attractive opportunities there can be complications. Before dealmakers are swept up in co-investment fever, they out to appreciate the potential unwelcome ramifications of co-investing.

Extra Complexity Could Slow Down or Kill Deals

A 2014 Preqin survey of fund managers found that 58% believed offering co-investments would slow down the deal-making process. Included among the listed reasons were:

1. Co-investments increase regulatory scrutiny (more on this later)
2. Complicated tax treatments
3. Objections from other LPs not receiving co-investment offers
4. Ineffective communication about the structure and process between partners

Pour through years and years of market research and investment surveys, and you’ll see that LPs need to focus on diligence and relationships, not just fees and returns. A 2016 Special Report reiterated that “the risk is greater” for co-investments, and participants need to evaluate their own risk-reward prospects.

Another underappreciated complication in a co-investment arrangement is realized at the end, not up front. Exit transactions are fairly straightforward when the GP has the autonomy to navigate all fund resources. This changes when a co-investor — who hasn’t signed away decision-making rights through a private equity fund — can object or drag feet.

This creates a fundamental dilemma for fund sponsors, who ostensibly don’t want to abdicate control or direct communication authority to co-investors. To combat this, many develop an agreed-upon process or infrastructure by which their co-investment partners work closely to ensure interests are aligned, yet leaves relative autonomy in the hands of the sponsor.

For co-investors, however, these kinds of “take-it-or-leave-it” structures often spoil some of the benefits of working outside the fund apparatus. If they feel as though their input is not recognized, appreciated, or sought out, LPs may balk.

Regulatory Risks

Outside of the economic and governance issues surrounding co-investment development, an ever-changing and hostile legal environment is encroaching the co-investment space.

The SEC issued a few warning shots between 2011 and 2015 about possible “conflicts of interest” in the private equity arena. According to a PricewaterhouseCoopers publication, examiners were most focused on “preferential allocation of lucrative co-investment opportunities to some limited partners and not to others” that might be disadvantageous to primary funds. Other areas of focus included stricter applications of federal securities laws, potential changes in tax laws, and even ERISA violations.

The Office of Compliance Inspections and Examinations (OCIE), one of the SEC’s capital market watchdogs, offers the most immediate compliance threat to co-investment deals. As important as relationships are in PE markets, being too cozy with a GP or advisor is a red flag for regulators. Scrutiny tends to be more intense when pension funds are involved, but all actors need to prepare adequately for compliance concerns.

Regulatory authorities have pushed for the power to mandate co-investment rights be available to all limited partners in an agreement. Ultimately, the regulatory treatment of LPs and GPs in a co-investment agreement isn’t settled, but there is no question that popular political sentiment is against anything associated with “private equity” or “venture capital,” including co-investments. This makes it a riskier proposal, and one where problems might not creep up until long after an investment occurs.

Foreign investments aren’t necessarily any cleaner. One German bank told Preqin that “We cannot co-invest as much due to bank regulations”; concerns were echoed by a Saudi investment company. If the Basel III and Solvency II Directives are fully implemented, it will be more difficult to capitalize on future opportunities.

Solution: LPs Shouldn’t Overreact

Don’t get me wrong: There are plenty of reasons for limited partners to like co-investments. They are a desirable aspect of the private equity scene; they just aren’t a panacea. LPs must still perform diligence for co-investments around the same major factors as traditional fund investments, except that fund dynamics are a little less constricting.