SEC calls out conflicts in how GPs allocate co-investments

Co-investments have been a hot topic in private equity as more limited partners seek ways to build direct exposure alongside their trusted GPs in investments.

GPs are not following their own policies governing how they disclose and allocate co-investments to investors in funds, creating conflicts of interest, according to the SEC in its latest risk alert published this week.

The SEC “observed private fund advisors that disclosed a process for allocating co-investment opportunities among select investors, or among co-investment vehicles and flagship funds, but failed to follow the disclosed process,” the alert said.

Also, some GPs had agreements with investors to give them preferential looks at co-investment opportunities without adequately disclosing those arrangements to all LPs, the alert said.

“This lack of adequate disclosure may have caused investors to not understand the scale of co-investments and in what manner co-investment opportunities would be allocated among investors,” the alert said.

Co-investments have been a hot topic in private equity as more limited partners seek ways to build direct exposure alongside their trusted GPs in investments. Almost 70 percent of respondents to Coller Capital’s Winter 2019/2020 LP survey said they co-invest alongside their GPs, with 44 percent of them proactively seeking co-investment opportunities.

Among the largest investors (those with $50 billion or more of assets under management), 84 percent said they were looking for co-investment activities, and 36 percent of such investors prioritise GPs likely to provide co-investments, the survey said.

Co-investments have the potential for fat returns and also cut down on the cost of the asset class as most GPs offer co-investments to investors with no obligation to pay fees or carried interest as part of the deals.

They also come with higher risk as they are concentrated bets on one business, as opposed to a passive commitment to a fund comprising a diverse selection of investments. LPs try to ease this risk by building diversified portfolios of co-investments.

“We’ve been focused on ensuring there’s adequate disclosures of those arrangements,” said Chris Hayes, senior policy counsel at Institutional Limited Partners Association.

“Often, you’ll hear, ‘LPs can just negotiate for what they need,’ but that doesn’t really help you” if GPs aren’t following their own policies, Hayes said.

ILPA’s best practice recommendations call for GPs to be transparent with all LPs about how co-investments are allocated. GPs should disclose in advance, through the private placement memorandum, limited partnership agreement and regulatory filings, about how co-investment opportunities, interests and expenses will be allocated among the fund and participating co-investors, according to ILPA’s Principles.

Disclosure should include any arrangements for prioritisation of co-investment allocations for certain investors as well as any deals set out in side letters, ILPA recommended.

The SEC’s alert stems from the advisor examinations it performs each year. Other findings include conflicts the agency found in secondary restructuring processes, transparency around fees and expenses and financial relationships between firms and their investors.

The SEC’s alerts can lead to enforcement actions, or further communications with managers.