Co-investment is an area that many institutional investors look for when investing with a fund manager. It’s generally a good deal for them because the investment is overseen by the fund manager without having to pay the fund management fee. Depending on the program, it may be a lesser fee or no fee. And of course they still have to pay the expenses charged by the fund manager to the portfolio company. The fund manager gets more capital to invest and can reduce the exposure of the fund to a particular investment. The fund manager is likely earning less of a fee for doing the same amount of work.
It does not seem like an area that is ripe with the conflicts and issues that grab the attention of the Securities and Exchange Commission. However, Marc Wyatt, the Acting Director, Office of Compliance Inspections and Examinations, chose to spend a few minutes raising the issue during his speech at the recent Private Fund Compliance Forum.
Another area where we have been dedicating resources is co-investment allocation. We’ve spoken before about our observation that co-investment allocation was becoming a key part of an investor’s thesis in allocating to a particular private equity fund, and over the past year, co-investments have become even more important to the industry.
If the SEC is dedicating some of its limited resources in this area, we should take notice.
While most of our co-investment observations have been around policies and procedures, we have detected several instances where investors in a fund were not aware that another investor negotiated priority co-investment rights. … Therefore, allocating co-investment opportunities in a manner that is contrary to what you have promised your investors can be a material conflict and can result in violations of federal securities laws and regulations.
From that quote it seems the SEC exam team has encountered situations where a fund manager was misleading investors about co-investment rights. Clearly, you can’t promise an investor something and then do the opposite.
Ironically, many in the industry have responded to our focus by disclosing less about co-investment allocation rather than more under the theory that if an adviser does not promise their investors anything, that adviser cannot be held to account.
Many fund managers do keep their co-investment allocations under wraps, doling them out in a manner that works best for the deal. There are many factors that go into partnering up with investor through a co-investment. The co-investor needs to be able make capital available and make decisions as quickly as the fund manager. Otherwise strategic decisions are jeopardized. The need for a co-investment may vary over the course of the fund life. Deals maybe smaller and not be good opportunities for co-investments.
I believe that the best way to avoid this risk is to have a robust and detailed co-investment allocation policy which is shared with all investors. … I am suggesting that all investors deserve to know where they stand in the co-investment priority stack.
I’m not sure I know what to make of that. Most investors do not have co-investment rights and have no expectation of co-investment opportunities. Some negotiate for contractual rights to co-investments. Others merely ask to be place in a pool of availability with no specific promises of opportunities.
Ultimately, it’s a contractual right negotiated between the fund manager and the investor. Clearly, the fund manager needs to live up to its contractual obligations with its investors. Failing to do so is an area appropriate for SEC intervention.
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