Rollover co-investments: The GP’s prickly friend

Reinvesting in a company you’re exiting has obvious benefits for a GP, alongside numerous challenges, writes Macfarlanes’ Alex Green.

As the pressure to deploy the significant pools of capital recently raised increases against a backdrop of a competitive market for quality assets, GPs are being forced to think more laterally about methods of driving value for their investors.

Sometimes one of the most attractive investment opportunities can be sitting right under a GP’s nose. When exiting one of its portfolio companies, a GP could choose to reinvest as a minority co-investor alongside the new lead investor in that portfolio company.

Alex Green, Macfarlanes
Green: rare for backseat driving not to create some tension

The attractions of reinvestment are obvious: a GP can crystallise value for its investors through the exit process but at the same time retain exposure to an asset which it has diligenced and managed for an extended period of time and which it believes has the capability to deliver further material upside for its investors.

There are notable challenges to any such strategy. GPs will need to ensure that any conflicts arising in respect to the transaction at the fund level are appropriately managed and carefully navigated. This is particularly relevant where the reinvestment is being made by another fund managed by the GP with the consequent potential for misalignment between investors in the GP’s relevant funds.

Another challenge arises at the level of the relevant portfolio company. The reinvesting GP will need to have a fundamental change in mindset. It will be going from the position of deal sponsor and lead investor to that of co-investor. Invariably this will mean relinquishing control of the portfolio company’s destiny and the ultimate timing and manner of exit from the portfolio company.

The reinvesting GP will also need to make sure that it is comfortable with the new lead investor from a relationship and strategy perspective, as the reinvesting GP’s success will be fundamentally intertwined with the new lead investor’s approach and decision-making with respect to the portfolio company.

There will also be challenges for investors seeking to acquire control of the portfolio company from the reinvesting GP. Whilst minority co-investment is not an uncommon feature of transactions, it is most usually restricted to portfolio company management teams and limited partners in the lead investor’s fund. In these circumstances, it is clear from the start that the lead investor will control the portfolio company and have the final say on key decisions. Lead investors will be much less used to a minority private equity co-investor with a controlling investor mindset, an (initially at least) deeper understanding of the relevant portfolio company and its own clear views on the best strategy for value realisation for a financial investor. These views may well be vocally represented both informally and formally at board meetings and it is rare for backseat driving not to create some tensions.

Lead investors will also come under pressure to accede to more favourable co-investments terms than they are classically used to. As part of the reinvesting GP’s auction process, bidders are likely to be invited to submit (alongside comments on the sale agreement and management term sheet) a markup of the reinvesting GP’s co-investment term sheet and will inevitably feel the pressure of the competitive process when assessing the co-investment terms proposed by the reinvesting GP. Particular areas of difficulty are likely to be around co-investor veto rights and exit provisions, where the reinvesting GP may be seeking to have material influence over key decisions and exit parameters such as timing, manner and valuation.

GP reinvestment can be a compelling area for GPs to explore in the current market but it is not without its challenges when it comes to implementation.

Alex Green is a partner at Macfarlanes based in London. He has a particular focus on private equity, fund secondary transactions, GP-led restructurings and private acquisitions.