The term co-investment “rights” could be considered somewhat of a misnomer in the private equity context. For most of the industry’s history, GPs would only very rarely promise specific terms in writing for a LP looking for co-investment opportunities.
But as private equity investors become more sophisticated– especially when it comes to handling co-investments and direct transactions – the dynamic is shifting. And a tougher fundraising environment has exacerbated the trend.
LPs willing to write big checks early will often want a side letter agreement that provides them first right of refusal for co-investment opportunities.
LPs with smaller bank accounts too are developing strategies to gain access to co-investment opportunities. According to industry legal sources, smaller LPs try to haggle for language in the LPA or in a side letter that says any co-investment deal offered to a LP of equivalent size must be offered to them as well (on the same terms).
GPs should be careful about writing explicit co-investment rights, says Claudio Siniscalco, a principal in the London office of fund of funds investor HarbourVest.
Siniscalco says that some of the very largest LPs have negotiated agreements that require a GP to provide co-investment opportunities at a percentage of their total fund commitment. For instance, an LP who commits $500 million to a fund, and negotiates that type of co-investment right at a 10 percent ratio, will need to be offered at least $50 million in co-investment deal flow by the GP. But Siniscalco warns that not all GPs will be able to honor these agreements.
This is because the ratios being agreed are too high, he reckons. And if multiple LPs have been afforded these rights, the GP would either need to vastly increase the amount of co-investment deals it would normally do, or start executing transactions well north of its investment mandate. Neither option seems particularly attractive.
Doing this level of co-investment is made even more difficult as not all LPs are sufficiently staffed to execute co-investments deals above a certain level in the timeframe required, elaborates Siniscalco. Instead, reckons Siniscalco, LPs are hungry for co-investment opportunities because they typically feature lower management fees – which LPs’ investment committees find especially appealing these days.
So why would a GP offer these types of co-investment rights? Aside from the obvious benefit they bring during fundraising, sources believe GPs offer them knowing that LPs will never take them up on all the co-investment opportunities brought their way. Whether or not that assumption turns out to be true however will be seen in the years to come.
For more on side-letter arrangements and the growing administration burden they now mean for GPs, see: “Asking for more on the side”, which originally appeared in the December edition of PE Manager.
