The future of private equity: Why co-investments are becoming increasingly popular
Why co-investments?
Strong reasons for co-investments are the potentially superior risk/return profiles that investors can achieve through co-investments. This is not only due to the typically lower co-investment management fees for investing in the flagship fund, but also the ability to customise the investment to the investor's preferences. In addition, investors have direct access to the deal and can build knowledge and expertise for their own future direct investments. Significantly, co-investments usually result in stronger relationships for the benefit of both managers and investors.
On the other hand, a co-investment allows the manager or general partner (GP) to manage the underlying target investment more efficiently, as risks can be split between the flagship fund and the co-investor. In addition, the GP is able to finance investments (including controlling positions) that would be beyond the scope of the GP without the contribution of the co-investors due to a lack of capital, certain investment restrictions at the level of the flagship fund (e.g. diversification requirements) or possible redemptions by investors at the level of the flagship fund. The concept of co-investments is therefore broadly diversified and covers many different situations.
Characteristics of co-investments
Regardless of how co-investments are structured (either as an alternative investment fund (AIF) or as a simple company), they have certain common characteristics. In general, co-investments can be categorised as investment opportunities that are offered to investors (both LPs of the flagship fund and others) at the discretion of the GP. In addition, co-investment vehicles will have access to selected investee companies in parallel to the flagship fund. However, in most cases, only limited information about the co-investments is provided in the fund documentation. A co-investment vehicle must be distinguished from a parallel fund structure, which is intended for investors with the same investment strategy but different tax, legal or regulatory requirements.
Structuring of co-investments
Co-investments can be structured as AIFs or simple partnerships. Apart from the general AIFMD test (e.g. the designation of an AIFM and a depositary) for assessing whether a structure constitutes an AIF or a simple partnership, various aspects relating to the investment strategy and the raising of capital must be considered. Depending on the characteristics of the individual case, these could result in the exclusion of the co-investment vehicle as an AIF.
Co-investments can be made through direct investments, whereby a voting agreement or a shareholder agreement on the exercise of voting rights in accordance with the fund strategy may be required. Apart from this, co-investments can also be made by independent units in the forms listed below:
- Asset management mandates
- Private loan agreements
- Companies/entities/funds allocated to a co-investor
- Company for joint investments of several co-investors (company for joint investments for co-investment with the flagship fund)
Conflicts of interest
In any case, co-investments must be structured in such a way that the interests of the fund are protected against the interests of the co-investors. Normally, these interests are congruent. However, this is not necessarily the case at the start of every project. Therefore, the structure and the corresponding effects in the set-up of the co-investment differ depending on the objectives (of the co-investors) and those of the other parties involved (passive fund investors, third-party investors or strategic co-investors).
In principle, the three different constellations of co-investors can be differentiated as follows:
- all co-investors are also LPs of the fund
- certain investors are not LPs of the fund
- the co-investors are not LPs of the fund
The structuring of the requirements varies depending on the function of the co-investors (active or passive investors, strategic partners or not).
Conclusion
Co-investments bring with them certain challenges that need to be overcome. Firstly, numerous operational issues such as the allocation of costs and fees, the valuation of the co-investments and the verification of the identities of the co-investors must be addressed. Apart from this, conflicts of interest must be clarified and the equal treatment of investors in both structures must be ensured. In addition, disclosure obligations must be ensured in a balanced and efficient manner.
In any case, an AIF has proven to be the most suitable structure to fulfil the needs of investors and managers in co-investments. VP Fund Solutions has the capabilities to provide its clients with a flexible workbench within well-known and widely accepted jurisdictions to further strengthen the substance and stability of co-investment structures.
