private equity co-investment considerations and structures
TRANSCRIPT
Private Equity Co-Investment Considerations and Structures
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TUESDAY, JANUARY 5, 2021
Presenting a live 90-minute webinar with interactive Q&A
Arash Farhadieh, Partner, Willkie Farr & Gallagher, New York
Laura Friedrich, Partner, Willkie Farr & Gallagher, New York
John M. Knapke, Partner, Willkie Farr & Gallagher, New York
Mark Proctor, Partner, Willkie Farr & Gallagher, New York
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Private Equity Co-Investment
Considerations and StructuresLaura Friedrich | Mark Proctor | Arash Farhadieh | John Knapke
January 5, 2021
Arash FarhadiehPartner
New York
Laura FriedrichPartner
New York
Mark ProctorPartner
New York
2
John KnapkePartner
New York
Speakers
1. Typical Co-Investment Structures
• Generally, an investment in a portfolio company (or other asset)
alongside an investment fund or similar vehicle
2. Sidecars
• Co-investment programs to invest alongside the main fund in all deals
meeting certain criteria (e.g., deal size or investment sector)
3. Annex Funds
• A fund formed to invest in portfolio companies of an existing fund,
typically after the existing fund has drawn down substantially all of its
available capital
4. Fundless Sponsors
• A manager that raises capital for investments on a deal-by-deal basis
Overview of Presentation
3
• Sponsor Perspective
o A co-investment can serve to fill a capital need – to address concentration
limits, for a larger-sized deal or to improve diversification of a fund’s portfolio
o Offering co-investments can enhance fundraising for a commingled fund
• Investor Perspective
o Co-investment opportunities offer the ability to gain additional access to desired
investments
o Co-investing alongside a sponsor provides a path to a direct-investment
program
o Co-investment fees are typically lower than fees for a commingled fund
Overview – Why Offer Co-Investments?
5
Commingled
Fund
Co-Investment
Vehicle
Portfolio
Companies
A, B, C …
Portfolio
Company
D
LP
LP
LP
Direct Co-Investors
LPsGP GP LPs
Overview – Typical Co-Investment Structure
6
• Investment Specific Vehicle
o Vehicle set up for a particular investment opportunity
o If along-side a fund, typically piggybacks off the fund documents
o Pros: sponsor controls all governance and exit decisions
o Cons: additional expense of operating a vehicle
Overview – Structuring Options for Typical Co-Investments
7
• Direct
o Investor becomes a direct owner of the asset
o Pros: investor has control of their own exit and governance
o Cons: target/sponsor may not want to deal directly with minority investors
Overview Structuring Options for Typical Co-Investments
(Continued)
8
• Additional Structures
o Within the existing fund (never actually seen it in practice, but have seen
plumbing for it in Fund LPAs)
o SMA/Fund of One
Overview Structuring Options for Typical Co-Investments
(Continued)
9
• Existing LPs vs. Strategic Co-investors
• Pro rata vs. priorityo Managing side letter obligations
• Timing and commitment processo Offering materials (PPM vs. marketing deck with risk/conflict disclosure)
o Equity Commitment Letter
o LPA (often marked against commingled fund)
o Subscription agreement vs. bringdown letter
o Can take as long as a full fundraise and be just as expensive
Offering Typical Co-Investments
10
• Management Fees/Carryo Market is all over the place (depends on the circumstances of the deal)
o Some are fee-free (especially if linked to a commingled fund; achieves a
blended fee rate)
o Sometimes just reimbursement of expenses and a back-end carry
o Sometimes just an up-front transaction fee and no management fee
o Clawbacks are less common
• Expenseso In the commitment or outside?
o Can be paid through recycling/current income
o Can be paid at the back-end out of distributions
o More often capped/budgeted as compared to commingled funds
• Broken Deal Expenseso Who pays?
o Significant disclosure issues for a linked commingled fund
Co-Investment Terms
11
• Follow-On Investmentso Better to have it committed (much more complicated in terms of dilution, share
classes, etc. if it is discretionary)
o Can reserve part of an initial commitment for follow-ons
o Preemptive rights
• Governanceo Removal, termination (usually at higher percentages or not permitted at all;
often linked to a commingled fund)
o LPAC - approve principal trades (who is on it? Often shared with a commingled
fund)
o Key Person rights are less common
o Veto Rights
• Side Letters
• Exitso Drags, tags
o What if an investor wants a longer hold?
Co-Investment Terms (Continued)
12
• Allocation of co-investments
o Adequate disclosure
o Fiduciary duties
o Complying with operating agreements/side letters
• Do you need an audit? Custody rule considerations
• Do you legally need a PPM? FINRA considerations; for CaymanIslands, private funds may all need PPMs now
• Co-investment sponsor is still an investment adviser; disclosure onForm ADV
Regulatory Considerations
13
• Sponsor Perspective
o Sidecars (sometimes referred to as overage or overflow funds), are programmatic co-investment vehicles
organized by a sponsor to invest alongside the sponsor’s main fund in each opportunity meeting certain specified
criteria (e.g., deals larger than a certain size or deals in specific sectors)
o These structures provide the sponsor with flexibility to pursue and consummate deals that might otherwise be too
large for the main fund (e.g., due to investment concentration restrictions in the main fund documents, or which
would cause the main fund to be over-exposed to a particular investment/sector) without having to resort to
leverage or syndication of investments to third parties
o In contrast to co-investment structures formed on an investment-by-investment basis as the need arises,
Sidecars provide the sponsor with a ready pool of capital that is available for deployment without the need for ad
hoc fundraising as and when specific opportunities arise, reducing the amount of time that might otherwise be
required to secure co-investment capital and providing greater certainty that capital will be available to
consummate a deal
o Investors in a Sidecar will not typically have the enhanced information or governance rights that are often
requested in the deal-by-deal co-investment context, and the sponsor can retain a greater deal of control over
the Sidecar’s investments than it would in the context of a deal-specific co-investment
o Sidecars allow a sponsor to charge fees and carry, albeit typically at reduced rates relative to the main fund
o The governing documents and commercial terms of Sidecars will typically be based on those of the main fund,
making them relatively easy to administer
Overview – Why Consider Sidecars?
15
• Investor Perspective
o Investing in Sidecars allows investors to gain additional exposure to a sponsor’s deals which they may not be
able to achieve by way of an investment in the sponsor’s main fund (e.g., where the main fund is oversubscribed)
o When investing in a Sidecar, an investor only has to diligence one set of documents, and does so upfront,
reducing the amount of time and effort that an investor must spend evaluating co-investment opportunities
o In addition, investments in a Sidecar often require less ongoing monitoring from an investor than traditional deal-
by-deal co-investments
o Because investments in Sidecars are typically subject to reduced fees and carry, by investing in a Sidecar an
investor can reduce the effective rate of the fees and carry they pay to a particular sponsor, thus improving their
overall net returns from that sponsor
o By that same token, investors in a Sidecar will typically have fewer information and governance rights than they
would in the context of a deal-specific co-investment
o The deployment of capital committed to a Sidecar depends on the opportunities sourced by the sponsor,
resulting in the risk that a Sidecar may not ultimately invest the capital committed by investors, leaving investors
paying organizational and ongoing expenses for a vehicle that makes fewer investments than anticipated
o Investments in Sidecars will typically be more concentrated than an investment in the main fund, and there are
conflicts of interest that may arise in connection with the investment activities of a Sidecar
Overview – Why Consider Sidecars?
16
• Fees and carry – Typically charged at a reduced rate relative to the main fund; fees may be based on invested
capital
• Allocation of investments – The main fund will have first priority
o In some arrangements, the main fund will take 100% of the opportunity until the sponsor determines that the
main fund has received an appropriate amount, with the Sidecar receiving the remainder; in other
arrangements, the main fund and Sidecar documents may prescribe a particular allocation methodology (e.g.,
with the main fund receiving priority up to a certain threshold, with any remaining amounts shared between
the main fund and the Sidecar until the main fund reaches its maximum concentration limit)
o Many Sidecar arrangements will provide considerable discretion to the GP to vary from the stated allocation
methodology (and, in some situations, bypass the overage fund and offer excess allocation opportunities to
third party co-investors) in appropriate circumstances
• Investments and dispositions – Typically made pari passu with the main fund in the same type and combination of
securities, at substantially the same time and on substantially the same terms as the main fund invests and disposes
of investments (subject to legal, regulatory and tax considerations)
• Investment period and term – Typically tied to the investment period and term of the main fund
• GP Removal and fund termination – Typically will occur automatically upon the removal of the main fund’s GP or
termination of the main fund
• Consent matters – Typically rely on the LPAC of the main fund to clear conflicts, though will often provide the
flexibility to form a separate LPAC for the Sidecar to address any conflicts on which the interests of the main fund and
the Sidecar diverge
Common Sidecar Terms
17
• Conflicts are inherent in any co-investment arrangement, including Sidecars, and
the conflicts may be more acute in situations where some of the Sidecar investors
are not also investors in the main fund
o In particular, conflicts are likely to arise in the allocation between the main fund and the
Sidecar of investment opportunities, common expenses, fees received from portfolio
companies and the sponsor’s time and attention
• Conflicts can be mitigated by including prescriptive language in the governing
documents of each of the main fund and the Sidecar providing how conflicts will be
resolved
o The less prescriptive the language in the documents (i.e., the more discretion granted to
the sponsor), the greater the potential for conflicts that are not clearly addressed
o In situations where conflicts arise that are not addressed in the fund documents, sponsors
may need to seek investor or LPAC consent to the sponsor’s proposed resolution of those
conflicts
• Conflicts should be clearly disclosed to investors in each of the main fund and the
Sidecar in their respective offering documents
Sidecars – Addressing Conflicts
18
• An Annex Fund is a fund formed to invest in portfolio companies of an
existing fund, typically after the existing fund has drawn down or reserved
for investments and expenses substantially all of its available capital and it
does not expect any recyclable proceeds in the near future
• Historically Annex Funds have been raised to support an existing fund’s
portfolio companies that may be experiencing difficulties typically due to
macroeconomic, or sector, developments
o For example, during the global financial crises, and more recently the energy
sector dislocation, a number of Annex Funds were raised
• More recently, a variation of the traditional Annex Fund has become more
prevalent, specifically to support the portfolio companies of growth equity
funds where the existing funds are performing well and the nature of the
underlying companies is such that additional growth capital is needed
(either to help the portfolio companies develop or to fund strategic
acquisitions) in order to fully realize the potential for the portfolio
What is an Annex Fund?
20
The term Annex Fund is sometimes used interchangeably with a Top-Up
Fund or a Build-Up Fund – while in some circumstances those terms are
appropriate in other circumstances the latter refer to co-investment/overage
funds discussed earlier
Depending on the specific needs of an existing fund’s portfolio companies,
their maturity and return profile, aside from an Annex Fund, GPs may
consider alternatives to Annex Funds, including the following:
• GP-led secondaries and continuation funds:o GPs looking for a long-term liquidity solution can sponsor a new fund, known
as a “Continuation Fund,” that would acquire and continue to hold interests in
one or more pre-identified portfolio companies held by the existing fund
o The success of a Continuation Fund will depend on the nature of the
underlying portfolio companies, their economic prospects and needs and
maturity of the overall portfolio – in many circumstances, a Continuation Fund
is a not a feasible option
Alternatives to Annex Funds
21
• Preferred equity lineso GPs can offer additional interests in the existing fund, which may either be
offered as the same class of interests held by existing investors in the fund
(i.e., “pari passu interests”) or as preferred securities, which pay a fixed
amount to new investors in priority to the fund’s existing waterfall
o An offering of pari passu interests requires the GP to address a number of
issues and conflicts of interest such as the valuation of the underlying portfolio
in order to establish the subscription price for the offered interests and dilution
of interests of the existing investors
Because of these issues, it is preferable in many instances for the fund to
issue preferred interests
o Given the complexity and financial impact both on existing LPs and the GPs’
potential carry, GPs need to carefully weigh the benefits and costs associated
with this alternative
Alternatives to Annex Funds (Continued)
22
• NAV or Asset-backed facilitieso A NAV facility is a credit facility that is non-recourse to the Fund and secured
by pledging the Fund’s interests in all or some of its portfolio companies, and
the proceeds from the NAV facility will be used to provide additional capital to
its portfolio companies
This type of a facility works exceptionally well where the underlying
portfolio companies are performing and producing cash flows
o The Fund’s governing agreements should be carefully reviewed to ensure that
entering into such NAV facility is permitted and is consistent with its terms,
relating to, among other things, recycling, borrowings, and follow-on
investment limitations
Separately, the governing documents of each portfolio company must be
reviewed to ensure that the Fund is permitted to implement the pledge
• Given the complexity involved in organizing an Annex Fund, GPs will often weigh
alternative options and will make a determination based on the performance and
needs of the portfolio companies and feedback from LPs
Alternatives to Annex Funds (Continued)
23
Existing Fund
Portfolio
Existing Fund’sLPsLPs New
LPs
Add‐on Investments in debt or equity
Annex Fund
Typical Annex Fund Structure
24
• Key considerations for GPs include:
o Conflicts of Interest
GP’s entitlement to management fee and carried interest in the Annex
Fund
GP’s commitment to the Annex Fund
Purchase price determination in respect of Annex Fund’s investment in the
existing fund’s portfolio companies
Annex Fund interest offered to current investors in the existing fund pro
rata based on their relative commitments vs. offering to any new third
party investors
Allocation of the investment opportunities between the Annex Fund and
the existing fund (where recyclable capital becomes available)
Annex Funds: Key Considerations for Private Equity GPs
25
• Key considerations for GPs include:
o Terms of the Governing Agreement of the existing fund and Regulatory
Matters
The governing agreement of the existing fund should be reviewed to
assess the restrictions and required consents and/or amendments
To ensure compliance with the requirements of the Advisers Act (as well
as from an investor relations perspective) GPs should proactively engage
their existing LPs and LPACs, and put in place robust disclosures and
mechanics to appropriately address LP/LPAC concerns
o Economic Terms of the Annex Fund offering
GP’s economics attributable to an Annex Fund will depend in part on the
reasons for its formation, e.g., where the Annex Fund has been formed
because of underperformance of the existing portfolio, LPs may require no
fee or carry or a tiered fee or carry
Annex Funds: Key Considerations for Private Equity GPs (Continued)
26
• Key considerations for existing fund LPs include:
o Whether third party investors will be able to participate in the Annex Fund or if it
will only be offered to the existing fund’s LPs
o Will the Annex Fund participate in all follow-on investment opportunities or a
select identified group of the portfolio companies? If all portfolio companies,
how will investment opportunities be allocated if the existing fund has available
capital (e.g., due to recycling)?
o Purchase price mechanic in respect of Annex Fund’s investment in the existing
fund’s portfolio companies – e.g., will the GP obtain independent valuation or
fairness opinions? Is there a distinction between primary and secondary
investments?
o GP’s entitlement to management fee and carried interest in the Annex Fund – if
the existing fund is not performing, LPs may require that the carry be
aggregated across the funds or impose a tiered waterfall
o GP’s commitment to the Annex Fund
Annex Funds: Key Considerations for existing fund LPs
27
• Annex Fund Formation:
o Full suite of typical fundraising documents should be prepared, with particular
focus on ensuring that the offering documents include full disclosure of conflicts
of interest, in particular if third party investors will participate in the Annex Fund
o Detailed disclosure of the performance of the existing fund’s portfolio
companies should be included in the offering documents as well as any
material expected developments in respect of the portfolio
o LPs/LPAC of the existing funds should be consulted in a transparent manner,
including in respect of potential changes in the existing fund’s portfolio, for
example, if a portfolio company receives a meaningful offer or LOI
Annex Fund Fundraising
28
• In circumstances where the Annex Fund is being formed to provide
follow-on capital to distressed assets (e.g., during a financial crisis),
the LPs will likely be more proactive and will expect steeper discounts
in fees and carry
• For a distressed portfolio, LPs will also be more likely to identify the
specific group of investments they want the Annex Fund to participate
in and may demand fairness opinions
Investor Reactions to Annex Funds
29
• A fundless sponsor is a manager that raises capital for
investments on a deal-by-deal basis
• There is no blind pool – the manager must shop each
individual deal to limited partners
What is a Fundless Sponsor?
31
• Useful for teams who are looking to raise capital without a
track record, or who have had prior track record issues
Why Adopt a Fundless Sponsor Model?
32
Pros: • Can raise capital relatively quickly and inexpensively (single-asset fund can be
raised in 4-8 weeks, as opposed to 2 years)
• Investments not cross-collateraized – GP earns carry on each successful deal
at the time of realization (or full LP payout), without having to worry about
clawbacks
• GP does not need to spend as much time/resources on fund management
aspect
• Few allocation issues
Cons:• Need to raise capital and execute deals at the same time – this requires
twice the energy
• Targets / sellers prefer a counterparty with capital at the ready – may lose
out in competitive processes without capital lined up
• Manager usually pays all broken deal expenses
• No committed capital means smaller fee base
What are the Pros and Cons of the Fundless Sponsor Model?
33
• 1-2% management fee
• 10-20% carried interest, sometimes with escalation provision
• Term of 5, 7 or 10 years (10 is considered long)
• No investment period – all capital contributed at closing
• Expenses and management fees are often outside of commitment
o Operating expenses may be subject to a cap
GP may seek to exclude indemnification expenses from this cap
o Expenses may be paid by portfolio company directly
o Management fee may be paid out of cash flow or capital contributions
• Each investment vehicle has follow-on rights
• LP giveback – GP will seek to recall 100% of distributions
• Often no LPAC because investors tend to be individuals and family offices
Market Terms for Fundless Sponsor Model
34
• Conflicts of interest tend to be simpler in fundless sponsor deals, because
each partnership tends to have its own discreet investment
• Unlike co-investment vehicles, do not have fund-related allocation issues, and
do not have issues around which fund gets an allocation of an investment
• Fundless sponsors often want to preserve the optionality to roll their
investments into a fund, or merge multiple investments together into a single
vehicle
o Merger requires consent of LPs in both vehicles
Often build consent provisions into both vehicles’ organizational
documents
o Roll-up requires consent of LPs in vehicle and consent of fund
Build consent provisions into vehicle’s organizational documents
Fund consent obtained in fund organizational documents or by
LPAC
Conflicts of Interest – Fundless Sponsor Deals
35
Investment Adviser Registration• Fundless sponsors need to consider investment adviser registration thresholds
o NY: Exempt reporting adviser registration at $25mm; full registration at
$150mm
o If first vehicle has $150mm or more in assets, registration is required
immediately
o Fundless sponsors often try to keep first vehicle below $150mm – allows them
to delay registration for longer period of time
Fundless Sponsors - Regulatory Considerations
36
Broker-Dealer Issues• Finder’s Fees
o Broker dealer issues often arise in the context of fundless sponsor deals, where relying on a network of
finders, who are not registered as broker dealers
o Paul Anka No Action Letter (1991) – allows for payment of cash finder’s fee under very limited
circumstances
o Outside of bounds of Paul Anka letter, very difficult to compensate finders
o Some investors will set up their own aggregator vehicles to invest in a fundless sponsor vehicle and
charge second level of management fee
• Fees Paid by Portfolio Companies
o Transaction Fees: GP should not take transaction-based compensation from portfolio company unless GP
is a registered broker dealer or there is a full management fee offset – Blackstreet No Action Letter (2016)
GP may be entitled to reasonable compensation for work in connection with diligence/pursuit of
transaction
o Consulting Fees / Monitoring Fees: portfolio companies may pay GP a consulting or monitoring fee on an
ongoing basis, so long as such fee is fully disclosed to limited partners
Any accelerated monitoring fee payments (paid upon early exit of investment) must be fully
disclosed
Fundless Sponsors - Regulatory Considerations
37