Co-Investment: How Private Equity Firms Can Protect Themselves and Still Make Their Investors Happy

Co-investment is a major topic in the private equity industry these days. General partners of private equity funds are faced with more and more demand from investors for co-investment opportunities or, at a minimum, the option to co-invest in the future. The prevalence of these arrangements has drawn the attention of the Securities and Exchange Commission, which is concerned about the implications for an investment manager’s fiduciary duty to its original fund and other investors. Fortunately, the SEC has provided guidance to private equity managers on how they can enter into these transactions while still fulfilling their fiduciary duties.

The main goal of a private equity firm is to find good investment opportunities for their investors’ pooled funds. If the transaction is profitable, all the limited partner (LP) investors benefit to the extent of their contributions, and the fund manager receives a fee tied to the fund’s performance. Sometimes an opportunity comes along that is so appealing to a particular investor that the investor asks to partner with the fund on the investment. Thus, rather than sharing in the opportunity pro rata with the other LPs, the co-investor will have an even greater personal stake in the investment and a potentially greater return.

The potential problem with co-investments is that investment managers have a fiduciary duty to all fund LPs. This includes a duty of loyalty (ensuring the adviser will not co-opt any opportunities that the fund may enjoy) and a duty of disclosure (demanding transparency to all investors of co-investment agreements). If the fund chooses to co-invest with a LP rather than take an opportunity entirely for itself, there is a risk that the manager is giving preference to one of its LPs over the others. If this possibility is not disclosed in the offering documents, the fund may have violated its duty to be transparent to all its investors.

With co-investment arrangements becoming increasingly common among private equity investors, the SEC has turned its attention to the potential conflicts these transactions create. Echoing similar comments made by the SEC back in 2015, Chris Mulligan in the chief counsel’s office at the Office of Compliance Inspections and Examinations recently explained what concerns the SEC about these relationships. First, there are concerns that the fund is choosing to benefit one LP at the expense of the others. Funds frequently offer co-investment at a reduced fee to the co-investor, meaning that the co-investing LP is getting the same investment at a lower rate than is charged to her fellow LPs. The second concern is one of disclosure. It is important to the SEC that all LPs are aware—before they make an investment with the fund—what standard the fund will employ in considering future co-investment opportunities.

Many private equity firms feel that, to stay competitive, they must continue to offer their investors the option of co-investment. Firms must therefore evaluate how best to pursue these transactions consistent with the fund’s fiduciary duties, thereby avoiding trouble with the SEC and the fund’s investors. As with many private equity issues, the first rule is transparency. If funds are clear with their LPs, they have a much greater chance of exploring co-investment opportunities without running afoul of their fiduciary duties. The best approach is to include a general co-investment policy into the fund’s private placement memoranda and limited partnership agreements, and then stick to that policy. The policy should cover how co-investments will be offered, how they will be structured (for instance, how broken deal fees will be divided), and whether all LPs will have the right to request co-investment. Then the fund must follow that policy, and do so consistently. As Mr. Mulligan explained, if co-investment is not addressed in these governing documents, the fund better have a really good reason for pursuing a co-investment rather than taking the opportunity for all of its investors.

CFPB Unveils Disclosure Forms in Response to Overutilization of Overdraft Fees

On Aug. 4, the Consumer Financial Protection Bureau (CFPB) released the results of its study into frequent overdrafters and four overdraft disclosure model forms as part of its Know Before You Owe initiative. The CFPB designed these one-page prototypes to help consumers understand the costs associated with opting into overdraft coverage and in an effort to improve the model form that financial institutions currently use. As of 2010, consumers must “opt in” to coverage so that when the consumer attempts to use his/her debit card or retrieve money from an ATM in an amount that exceeds his/her account balance, the bank allows the transaction and the consumer pays a fee after the fact. If the consumer has elected not to opt in, such a transaction will be declined and no fee will be incurred. Continue Reading

Revisiting the Enforceability of Class Action Waivers in Consumer Financial Contracts

On July 19, 2017, the Consumer Financial Protection Bureau (CFPB) published the final Arbitration Agreements Rule (the rule) that would impact the way claims involving consumer financial products and services are handled in the future. The rule prohibits providers of consumer financial products and services from relying on a predispute arbitration agreement that includes an arbitration clause that bars a consumer from filing or participating in a class action.

The rule would apply to “providers” of covered consumer financial products and services. The rule defines a “provider” as:

  • A person or entity that engages in an activity that is a covered consumer financial product or service if not otherwise excluded for the rule, or to the extent that the person is not specifically excluded from coverage under the Arbitration Agreements Rule; or
  • An affiliate of such a person, when the affiliate is acting as that person’s service provider.

Generally, covered products or services are those offered or provided to consumers primarily for personal, family or household purposes, or that are offered or provided in connection with another financial product or service that is offered or provided to consumers primarily for personal, family or household purposes. The rule covers various consumer financial services, including, but not limited to, core banking depository and consumer credit products, debt relief providers, servicing or collecting certain credit products, and check cashers. Continue Reading

FTC Enters Into $104 Million Settlement With Company for Impermissible Lead Generation

On July 5, 2017, the Federal Trade Commission (FTC) entered into a stipulated order to memorialize a settlement with a lead-generation business, Blue Global LLC, and its CEO (Blue Global), in the U.S. District Court for the District of Arizona. The settlement entails both injunctive relief and an award of more than $104 million in damages, all arising from allegations that Blue Global’s “ping tree” lead-generation tool ran afoul of the FTC’s prohibition on unfair or deceptive acts or practices. The settlement comes as the result of the FTC’s complaint filed only days earlier (on July 3).

Blue Global operated a lead-generation business. In its complaint, the FTC alleged that Blue Global operated at least 38 internet domains that offered services to consumers looking for loans. The complaint also alleged that consumers were encouraged to fill out online applications, then “sit back while we do the dirty work” of matching those applications with a “network of more than 100 lending partners.”[1] These applications allegedly required consumers to provide personal information – including their name, address and contact information – as well as sensitive personal information such as Social Security numbers, financial account numbers, and credit and debit card information. Continue Reading

H.R. 2148 Introduced to Clarify HVCRE Rules

In 2013, the Federal Reserve Board adopted rules to implement Basel III, a regulatory framework of reform measures for the banking industry issued by the Basel Committee on Banking Supervision (BCBS). These measures include a set of recommendations on banking regulations which, in general, aim to ensure banks are sufficiently capitalized to withstand volatile market conditions such as those that marked the financial crisis of 2008. Effective Jan. 1, 2015, as part of the Basel III regulations, banking organizations are required to set aside more capital in reserve when making commercial real estate loans considered “high-volatility commercial real estate (HVCRE) exposures” than what had been historically required for typical commercial real estate loans. Under the HVCRE rules, a non-HVCRE commercial real estate loan carries a risk weight of 100 percent, whereas an HVCRE loan has a risk weight of 150 percent; in other words, a lender is required to maintain 50 percent more capital on reserve against an HVCRE loan – a significant increase. Continue Reading

Commercial Tenant Debtors in Chapter 11: Fundamentals of Landlord Creditor Protection in Bankruptcy

Commercial landlords have unique protections in bankruptcy, but can lose these rights if they do not assert them. When a commercial tenant files bankruptcy under Chapter 11, the landlord must carefully monitor filings and proceedings from the first day to be sure that the debtor properly budgets for payment of rent, and does not otherwise seek to modify the landlord’s rights and remedies. The fundamental rule of bankruptcy is that creditors have certain rights unless they give them away. The Bankruptcy Code (i.e., Title 11 of the U.S. Code) won’t protect a sleepy creditor who fails to object to motions, sale orders, a plan, or a confirmation order that strikes a creditor’s claim, modifies the lease or otherwise eliminates the landlord’s protections. Consequently, commercial landlord creditors must carefully monitor bankruptcy proceedings to enforce their rights and maximize their recovery.

  • 365 – Assumption, rejection and the obligation to pay rent commencing 60 days after the petition date

Section 365 of the Bankruptcy Code is the primary statute addressing unexpired leases. The same Code section also deals with “executory contracts.” Among its virtues, § 365 is long and confusing; has different rules for different chapters and for different types of leases; is replete with terms defined elsewhere and cross-references to multiple other statutes; and is subject to alteration by a number of other statutes that aren’t referenced. It’s a challenging statute.  Continue Reading

Supreme Court to Determine Whether Internal Whistleblowers Are Protected From Retaliation

On June 26, 2017, the Supreme Court granted certiorari on an issue that has long divided the federal courts: whether a whistleblower is entitled to protection from retaliation for blowing the whistle internally even if he or she doesn’t report to the Securities and Exchange Commission (SEC).

The Supreme Court granted certiorari of the Ninth Circuit Court of Appeals’ decision in Somers v. Digital Realty Trust Inc. et al. which upheld the ability to bring anti-retaliation claims by a whistleblower who did not make a report to the SEC. The Ninth Circuit’s decision held that the Dodd-Frank Wall Street Reform and Consumer Protection Act’s (Dodd-Frank) “anti-retaliation provision unambiguously and expressly protects from retaliation all those who report to the SEC and who report internally” (emphasis added).

However, many courts have found that these provisions are anything but “unambiguous.” In his dissent in the Somers case, the Ninth Circuit’s Judge John B. Owens recognized (and came out on the opposite side of) the ongoing circuit split regarding this interpretation of Dodd-Frank. Continue Reading

Policymakers Increasing Their Scrutiny of Virtual Currencies

Virtual currencies are attracting unprecedented worldwide attention from not only businesses and investors but also U.S. policymakers.

The increasingly intense interest in virtual currencies is fueled by all-time highs in the price of bitcoin and other virtual currencies, excitement generated by the flood of POCs (proofs of concept) using the underlying technology, the frenzy of fundraising stoked by initial coin offerings (ICOs), and the additional demand created by unfortunate ransomware attacks.

At the recent Consensus 2017 conference, which is one of the most significant events in the fledgling blockchain world, the predominant topics of discussion were the new virtual currencies and blockchain technologies being unveiled almost daily, the legality of ICOs, and how much and how fast the next ICO would raise money. Continue Reading

Supreme Court Holds That Filing of Time-Barred Bankruptcy Claim Does Not Violate FDCPA

On May 15, 2017, the United States Supreme Court issued its decision in Midland Funding, LLC v. Johnson, 581 U.S. ___ (2017) in which it held that filing an “obviously time-barred” proof of claim in a bankruptcy proceeding does not violate the Fair Debt Collection Practices Act (FDCPA).

The facts of Midland Funding are fairly straightforward. The respondent filed for personal bankruptcy under Chapter 13 of the Bankruptcy Code (Code). Midland, the petitioner, filed a proof of claim in the respondent’s bankruptcy on account of a credit card debt. The proof of claim, however, demonstrated that the debt was barred by the applicable Alabama statute of limitations. The respondent’s counsel objected to the claim, Midland did not respond, and the Bankruptcy Court disallowed the claim. Continue Reading

Supreme Court Holds That Cities Have Standing to Sue for Fair Housing Act Violations

On Monday, in Bank of America Corp. et al. v. City of Miami, Florida, the Supreme Court held in a 5-3 decision that the City of Miami had standing to challenge alleged violations of the Fair Housing Act by lenders. 581 U.S. ____ (2017). The Supreme Court left open whether there was a “sufficiently close connection” between the alleged misconduct and the injuries claimed by Miami (including reduced property tax revenue and increased police and fire expenses) to allow Miami to recover.  Continue Reading

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