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.