In Focus: Getting the terms right on co-investment

Co-investments offer substantial benefits to limited partners. As well as being economically attractive – they tend to offer favourable terms, helping investors to enhance the aggregate returns of their private equity portfolio – they can also provide valuable insight into how a sponsor works with management and adds value to the companies in which it invests.

But they also present challenges that are very different from those arising from limited partner investments in private equity funds and from direct, control investments in operating companies. Co-investments are typically structured so that the co-investors have no meaningful control over the ultimate operating company; instead, they are required to “ride along” with the sponsor. It is therefore critical for co-investors to align their interests with those of the sponsor.

Short timelines are a common feature of co-investment transactions: co-investors should be prepared to work on the sponsor’s timeline, which often means evaluating potential investments and their related legal documents within a matter of weeks or even days. Transaction sponsors view a co-investor’s ability to act quickly as an essential element of the process, since a failure to meet the specified deadlines could delay or even derail the closing of the transaction. 


EQUAL RIGHTS

The first legal document that co-investors typically receive in connection with a transaction is an equity commitment letter. A well-drafted letter will, at a minimum, identify the commitment amount, the co-investor protections that will be contained in the final transaction documents, and the circumstances in which the investor’s commitment will expire. The letter should also confirm that the co-investors (or the co-investment vehicle through which they invest) will acquire the same securities as the sponsor, at the same price and on substantially the same terms. 

Investors should be wary of the ‘sign-your-rights-away’ commitment letter that requires them to fund their investment at the sponsor’s direction, without receiving any meaningful legal protections or any specifics about the material terms of the transaction. 

When co-investors invest in an operating company directly, the relevant protections will typically be found in the company’s stockholders agreement, registration rights agreement and certificate of incorporation. When co-investors invest indirectly, through a separate co-investment vehicle that is established and controlled by the sponsor, the vehicle’s operative documents are typically drafted so that the investor protections contained in the operating company’s stockholders agreement, registration rights agreement and certificate of incorporation are passed through to co-investors, as if they had invested directly into the operating company. 

So what kind of protections should co-investors seek? The most effective way for co-investors to protect themselves is to insist on being treated equally with the sponsor who, presumably, will seek to act in its own best interests. Co-investors should not expect to receive all of the same rights as the sponsor, particularly with respect to voting rights, seats on the operating company’s board of directors, or the right to receive fee income from the operating company. But they can expect to receive equal treatment when it comes to the sponsor’s initial investment, potential follow-on investments, and sales of the operating company’s securities. 

To protect their investment from being diluted, co-investors typically receive the right to purchase their pro rata share of any equity securities of the operating company that the sponsor purchases. These rights should cover securities issued by the operating company and by its subsidiaries, and any purchases should be on a pari passu basis with the sponsor. 

To ensure that they don’t get left behind when the sponsor sells its securities of the operating company, co-investors typically insist on standard tag-along rights in connection with any exit by the sponsor. While co-investors can expect to receive these tag-along rights, they should also expect the sponsor to receive standard drag-along rights which enable the sponsor to force the co-investors to join in a sale of the operating company. 


AVOIDING NASTY SURPRISES

Co-investors should make sure that the relevant transaction documents do not expose them to unexpected or unlimited liabilities. Co-investors that invest directly into an operating company should pay particular attention to tag-along and drag-along provisions, because these provisions can require co-investors to enter into a range of agreements that the sponsor has negotiated on their behalf. To limit their potential exposure in these circumstances, co-investors can seek to limit the types of obligations that they will be required to incur. A co-investor might, for example, ask that it not be required to sign any document that would require it to be jointly and severally liable with any other party, to make representations and warranties that are materially different than those being provided by the sponsor, or to be liable under any indemnity provision for an amount that exceeds its net transaction proceeds.

Co-investors that invest through a co-investment vehicle should pay careful attention to the vehicle’s expense provisions, including those provisions related to indemnification. In particular, co-investors should have a full understanding of how expenses of the co-investment vehicle will be satisfied, including unforeseen expenses related to litigation and indemnification claims. Some co-investment vehicles require co-investors to contribute additional capital or return prior distributions in these circumstances. It is very important that any such obligation to contribute capital or return distributions are subject to specified caps, otherwise the co-investors may inadvertently have agreed to unlimited liability for expenses. 

The legal structure of the co-investment could have significant tax and other regulatory consequences for the co-investor. From a tax standpoint, a key issue to consider is whether the co-investor (or its beneficial owners) would be subject to any tax return-filing obligations as a result of the transaction. Another is whether (or to what extent) the ownership and disposition of the co-investment securities would result in any tax payment obligations for the co-investor.

These issues should be scrutinised carefully based on the particular circumstances of the co-investor, because the sponsor may – and, in many cases, will – have a tax profile that is different from the co-investor. Depending on the terms of the investment, the co-investor may be able to utilise techniques to minimise or reduce any tax filing or payment obligations that arise from the transaction. 

A co-investor subject to the U.S. Employee Retirement Income Security Act (ERISA) will need to consider whether the entity that it invests in potentially could hold ‘plan assets’ under ERISA and whether the investment could violate the restrictions under ERISA or the Internal Revenue Code against engaging in non-exempt prohibited transactions. The fiduciaries of an ERISA investor will also need to determine whether making the co-investment would be considered ‘prudent’ within the meaning of ERISA.

Limited partners seeking to enhance their portfolio returns through the lower fee structure associated with co-investments should not overlook the importance of getting the transaction terms right. Favourable transaction terms can contribute to the bottom line by reducing co-investors’ legal risks, while securing their access to attractive liquidity opportunities.