LPs using side letters to avoid co-investment carry

Investors in the same fund are getting different terms on co-investments, according to a survey of deals by law firm MJ Hudson.

Some GPs are charging LPs as much as 10 percent carried interest on co-investments – and others as little as zero percent – with prominent LPs using side letters to secure more favourable co-investment terms, according to lawyers MJ Hudson.

“More influential LPs are getting different deals through side letters – for example, some aren’t paying any carried interest on their investments. The level of fees charged on co-investment transactions highlights the favourable nature of these arrangements for LPs – investors in co-investment vehicles often receive preferential economic terms to incentivise them to take part in the deal,” Nikhil Nathwani, an associate at MJ Hudson who co-authored the report, told PEI.

In a survey of all co-investments it advised on in 2016, MJ Hudson also found that some LPs – particularly those who GPs feel are crucial to raising future funds – are using side letters to negotiate preferential co-investment deal rights and fee levels. Aside from differing carried interest terms, the law firm said the management fee being paid by LPs for co-investments ranges from zero to around 1 percent, lower than the customary 2 percent.

The survey also found that the GP management team very rarely invests any personal capital into co-investment vehicles, raising questions about alignment of interests.

“Ordinarily with blind pool funds we would expect GPs to make personal investments to the fund in the region of 1 and 4 percent of the total fund. The same cannot be said of co-investment deals, where GP commitment is often zero. The lack of team investment in these co-investment deals leads to potential misalignment of interests. LPs should be aware of that – but most are not” said Peter Mallon, co-author of the survey.

In a report accompanying the survey, MJ Hudson says GPs “need to be transparent with investors and provide full disclosure on where they stand in the co-investment pecking order. Where the GP has firmly agreed to provide certain investors with co-investment rights, it should disclose those rights to all investors.”