As private equity sponsors seek advantages in a saturated fundraising market, the ability to offer co-investment opportunities continues to be a useful tool to differentiate the manager from the crowd. While potentially allowing fund managers to execute on larger transactions without having to increase the size of their funds, sponsors also continue to dangle the co-investment opportunity “carrot” to prospective investors as a sweetener in order to secure their fund commitments.

The attractiveness of co-investment allocations to investors, of course, are the economics. While more and more co-investments include carried interest and/or management fee terms as demand for co-investments has reached its apex, these terms are typically still more favorable than the traditional 2 and 20 terms found in most private equity fund partnership agreements.

Given their advantageous terms, and the fact that all fund investors do not typically participate, as co-investment activity has increased, so has related regulatory scrutiny. Co-investment arrangements have been an area of focus of the SEC in the past few years as the agency seeks to ensure investor fairness and fulfilment of fund manager fiduciary duties. The recent attention on and scrutiny of these co-investment arrangements has been one of a small handful of topics that has stood out in the SEC’s continuing efforts to provide more resources in reviewing private equity fund practices generally, including their examination of registered investment advisers that manage private equity funds.

Two issues in particular that have attracted the interest of the SEC are how fund managers allocate co-investment opportunities among their investors (and whether their policies on these matters are adequately disclosed as part of a fund’s offering materials), and whether the allocation of fees and expenses among a fund and co-investors in certain situations is fair and equitable.

Allocation of Co-Investment Opportunity Among Investors

Competition for co-investment opportunities has become a prominent issue among the institutional investor community in recent years. Given their advantageous economic terms, obtaining co-invest allocations can provide an institutional investor with a way to improve the terms of its overall commitment to a fund. One of the fundamental themes inherent in the SEC’s review of a private equity fund manager’s practices and policies is fairness to all of its investors. To the extent that a manager provides an investor with more favorable terms than its investor base receives generally, there is an expectation that the arrangement (or, at least the ability to enter into a special arrangement) will be properly disclosed. In recent years, the SEC has indicated on several occasions that this disclosure requirement should apply in the context of offering co-investment opportunities to investors. There have been numerous indications from the SEC that it would be in a manager’s best interest to develop robust co-investment allocation policies that are shared with limited partners, though the agency has stopped short of requiring a specific formula. While the SEC has made a number of these types of pronouncements, there has not yet been any enforcement action that might cause industry norms to develop around co-investment offerings and disclosure. Certain managers are still taking the “less is more” approach in their fund disclosure documents, under the theory that by simply stating that they may offer co-investment opportunities to investors based on whatever methodology they choose, they are effectively putting what is typically a sophisticated investor base on notice. Other fund managers have opted to address the message being put out by the SEC by providing a fulsome co-investment allocation policy to their investors that has a specific methodology for determining allocations. It is likely advisable, at a minimum, to provide disclosure that at least falls somewhere in the middle of this spectrum – i.e., a relatively detailed description of the numerous factors that a fund manager may take into account when determining how it will allocate co-investment opportunities. Many of these factors may provide a reasonable justification for selecting a particular investor for an opportunity – for example, based on the size of an investor’s commitment to the fund, or the ability of an investor to review and approve an offered investment opportunity quickly and efficiently.

“It is likely advisable, at a minimum, to provide…a relatively detailed description of the numerous factors that a fund manager may take into account when determining how it will allocate co-investment opportunities.”

Allocation of Fees and Expenses

Several recent settlements between the SEC and private equity fund managers have highlighted the regulatory body’s recent focus on ensuring that co-investors bear their proportionate share of fees and expenses related to a transaction – particularly where fund limited partners have not been informed that the fund will carry the costs in question.

Most private equity funds provide for a management fee “offset” – a reduction of the fund level management fee charged to limited partners to the extent of any fees earned by the fund manager or its affiliates from the fund’s portfolio companies. The market is trending towards a 100% offset mechanic, although a number of funds have been able to retain anywhere between 20% and 50% of portfolio fee income, depending on a manager’s particular circumstances. While many may assume that all fees earned by a fund manager with respect to a particular transaction are applied to the management fee offset mechanic, where a fund manager has brought in additional co-investment capital to a deal, a reasonable argument could be made that only the portion of the portfolio company fees allocable to the fund’s investment should be applied to the fund management fee offset, thus allowing the fund manager to keep that portion of fees allocable to the co-investment piece. However, the SEC has recently made it clear that the fund manager must not be ambiguous in its fund documentation as to its offset methodology where it only offsets the fund’s allocable portion of fees. A settlement with a fund manager in the summer of 2016 led to the reimbursement by the fund manager of approximately $12 million in fees it had retained and the payment of several million dollars in fines. The SEC found that that the fee offset methodology in the fund documents was ambiguous, and that therefore the fund manager acted improperly by allocating only the fund’s proportionate share of the portfolio company fees earned by the manager to the management fee offset, rather than the entire amount of fees earned.

Another situation involving misallocations of fees and expenses among a fund and co-investors sourced by the fund manager that has led to recent SEC enforcement action relates to the allocation of broken-deal expenses. A 2015 action was brought by the SEC against a fund manager for failing to fairly allocate broken deal expenses among its primary funds and certain co-investors, including vehicles through which certain in-house personnel of the fund manager were to participate in the proposed transaction. Typically, the limited partnership agreement or other governing documents of a private equity fund include a provision that provides that “fund expenses” include broken deal expenses, under the theory that these expenses are incurred by the manager for the benefit of the fund and its limited partners. However, many fund LPAs are ambiguous as to whether those broken deal expenses include the portion allocable to any proposed co-investors. The SEC in this case found that this lack of disclosure and subsequent allocation of the full broken deal expenses to the manager’s primary funds was a violation of certain provisions of the Investment Advisers Act. The fund manager agreed to pay nearly $30 million to settle the charges, including a $10 million fine. As a result of this action, managers bringing newer funds to market are specifically negotiating for the primary fund to be responsible for broken-deal expenses of co-investors. Unless clearly disclosed in fund documentation, broken-deal costs should not be borne exclusively by the primary fund.

“…as the co-investment market continues to evolve and become a more prevalent part of a private equity fund manager’s investment program, there will continue to be an increase in regulatory scrutiny of these arrangement to ensure fairness to investors.”

Conclusion

It is clear that as the co-investment market continues to evolve and become a more prevalent part of a private equity fund manager’s investment program, there will continue to be an increase in regulatory scrutiny of these arrangement to ensure fairness to investors. Fund managers – particularly those who are (or who plan to become) registered investment advisers – would be wise to ensure clarity on issues related to co-investments in their fund offering and governing documentation, and to be transparent with their limited partners in disclosing their approach in managing these arrangements.