May 13, 2014
Interviewed by: David Snow
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Negotiating a Co-investment Partnership

David Watson, an attorney with Goodwin Procter, shares legal insight into the co-investment partnership process. He discusses key negotiating points in today’s co-invest agreements as well as tells the extent to which large LPs have advantages over smaller ones in structuring these agreements with GPs.

David Watson, an attorney with Goodwin Procter, shares legal insight into the co-investment partnership process. He discusses key negotiating points in today’s co-invest agreements as well as tells the extent to which large LPs have advantages over smaller ones in structuring these agreements with GPs.

Co-investment: The Fine Print

With David Watson of Goodwin Proctor

David Snow, Privcap: Today, we’re joined by David Watson of Goodwin Procter. David, welcome to Privcap. Thanks for being here.

David Watson, Goodwin Proctor: Thank you. Thanks for having me.

Snow: You are an attorney and you structure a lot of partnership agreements. We’re talking today about co-investing so, within the work you, do you structure a lot of co-investment decisions both on the real estate and the private equity side? I’d love to hear your perspective about what’s going on in that activity. First, is it safe to say that co-investing is becoming more popular, at least in private equity?

Watson: Yes. We’re certainly seeing more of it. For years, investors have said they always want to co-invest but they actually haven’t been doing a lot of it. Now, we’re seeing more of them interested in it. They’re developing the internal capacity to do that. That’s the key—having people in-house who know how to do it. There are also structures we use where sometimes they don’t have to make the investment decision; it might be programmatic structure, where they go into every deal or almost every deal. So, there are ways that they can address that in-house expertise issue.

Snow: We can get into the different formats, but first, what are the key negotiating points when structuring a co-investment agreement between a GP and an LP? What do the negotiations tend to come down to?

Watson: There are two principle issues: economics and control over the investment. On the economic side, if you’re an investor in a co-investment, you’re focused on what you have to pay to get into this co-investment. That often will be negotiated in advance when the investor comes into the fund. So, they’ll negotiate when they have the most leverage coming into the fund for some reduction in the fees and carry from what they pay in the fund. I don’t think you could say there’s a market for fees and carry, but there certainly is a range of alternatives. Sometimes, we see there’s actually no fee and carry—come in without a load at all. Sometimes, they’ll come in with as much as half the fees and carry you’d pay in the fund. It really comes down to negotiating leverage and how badly the fund manager wants that investor into the fund.

Snow: Without being overly scientific, do larger institutional investors tend to have more leverage? Do they tend to pay less as co-investors than smaller groups?

Watson: Yes. They tend to get the co-investment in the first place more than smaller groups. When you think about co-investment being offered, it usually goes to the larger investors as an incentive for them to come into the fund. Sometimes, it will go to the smaller investors as a first closer. Sometimes, if you’re having trouble raising your fund, you’ll say to those investors who are willing to come into the first close, “We’ll let you come in without some period of paying a fee or some discount,” but often, you’ll also offer to them the ability to co-invest. That’s one more thing you can throw in as an inducement to come into the first close.

Snow: Have you seen funds where different LPs pay different amounts to co-invest? Is that a sensitive issue?

Watson: You don’t see a lot of it on the co-investment, but you do see it in the fund. Sometimes, the co-investment is structured so it is, effectively, a different fee. Once in a while, you’ll see it where the co-investment is co-investing in every investment opportunity at a fixed ratio, which is a reduction of your fees and carry. But it’s common to see investors coming into the fund get a break on the fees and sometimes on the carry. Again, sometimes just for those coming into the first close—as an inducement to do that, you give them a break on the fee. But, often, it’s those big investors; if you want the $100-million investor to come in and help seed the fund, you have to give them a break. It’s commonly accepted now.

Snow: Let’s talk about the allocation policies of the GPs or, at least, the need for some form of policy. Has there been a change with regard to how spelled out these co-investment allocation policies need to be?

Watson: Investors are very focused on that. I would say it’s over the last five or six years, rather than recently. There are a couple of reasons for the changes we’ve seen. One is the investor focus, making sure you’re not cherry-picking those opportunities. From the perspective of the investor coming into the fund, into the co-investment, who wants to know they’re being offered on a fair basis the things that come up, but more importantly, from the investors in the fund, who want to know I’m getting all the deals in accordance with the fund documents—you’re only offering the excess. Also, there are new requirements under the Advisors Act. Many private equity fund managers had to register a couple of years ago with the SEC as a registered investment advisor and, when you’re registered, you have to have an investment allocation policy. So, in addition to investors pushing you in that direction, the SEC pushes them in that direction of having a policy.

Snow: What is challenging about putting a policy together? Is the hardest part simply following the policy or is the phraseology difficult to come up with?

Watson: It’s almost impossible to come up with a policy that’s going to work perfectly in all situations. So, you can come up with a policy, for example, that rotates opportunities among those who have capital available for it. You can come up with a policy that says only the excess goes to certain investors. There are many ways to do that, but inevitably, something comes up along the way where you say, “This doesn’t make sense.” So, one difficult thing to think about in the policy is how to address this “doesn’t make sense” situation. Usually, there’s some ability to get approval, either from investors or from some subset of investors, to be able to do those investments that are outside the normal policy.

Snow: Final question. One complaint about private equity is that it’s a very resource-intensive, expensive asset class to be in. And if you get into co-investing as an LP, you probably need to hire more people and more expensive people. How does it work on the real estate side? Don’t you need whole teams to be able to manage some of these direct investments into property?

Watson: A lot of people are involved in things beside the initial investment. You definitely need to have people onboard for the initial investment so they can understand whether they should or shouldn’t go into this deal. But, after that, a lot of the decisions—like if you’re going to redevelop the asset, put debt on it, or have a major lease—are not made by the investor. They’re simply relying on the manager, assuming that the manager has the same incentive they do to make that asset the most valuable they can.

Snow: Do the co-investing LPs ever have the right to retain their stake while the fund sells its stake, or is that rare?

Watson: It happens in a few situations. It happens if it’s a public company. It’s a private equity deal—it was private originally, you took it public and you’re still holding the shares. In that scenario, it’s common to let all the investors do what they want with the shares. Also, you might see it in a situation where it’s already a minority investment. There’s not a lot to be gained from selling a block of the shares. But, if you have a buyout fund and that fund controls the company, there’s certainly a premium to be had from selling the block of shares rather than just selling the fund’s piece of it. That’s where, normally, you wouldn’t see the co-investor being able to sell on their own.

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