As private fund managers continue to seek out new ways to offer alpha to their clients, one structure that has garnered much interest is a co-investment fund or other special purpose vehicle (“co-investment vehicle”). Typically, co-investment vehicles are established to invest alongside the manager’s flagship products in one investment (whether public or private) or in a related group of investments falling under a single investment theme. Successfully raising and investing a co-investment vehicle requires advance planning. Often, the manager will need to set up its co-investment vehicles quickly, due to the need to deploy capital rapidly to take advantage of these opportunities. At the same time, these vehicles present distinct regulatory and business challenges that the manager may not have previously needed to consider. Moreover, the SEC has recently devoted considerable resources in the examination and enforcement arenas to co-investment arrangements. This memorandum will highlight the significant structuring and operational issues relating to co-investment vehicles, as well as those issues that the SEC and its staff have focused on publicly and in the examination setting, so that you will be in a position to access co-investment opportunities successfully.

• Who will be the target investors? Depending on whether the investors will be U.S. taxable, U.S. tax exempt and/or non-U.S. investors, the manager will need to make key decisions concerning the structure of the co-investment vehicle due to tax and other factors. For example, certain types of investments (e.g., equity in U.S. operating entities taxed as partnerships) may be tax inefficient for U.S. tax exempt or non U.S. investors. Managers must also consider at the outset whether its own personnel (“insiders”) will participate in the co-investment opportunity and, if so, whether a specified percentage will be reserved for them. Similarly, the manager may wish to offer the co-investment opportunity to existing investors who have expressed an interest prior to reaching out to third party co-investors. The SEC will expect the manager to have developed a policy in this area. The SEC has indicated that, while a manager may not be obligated to offer co-investment opportunities to all investors in its existing funds and accounts, it should disclose to those investors its policies regarding co-investment participation, including whether certain investors have specified participation rights in side letters etc.
• Will leverage be used? If leverage is to be utilized, U.S. tax exempt investors will prefer an offshore corporate structure to avoid unrelated business taxable income (“UBTI”).
• What will be the expected timing to make the investment? The time frame (and hence the speed with which issues must be resolved and documentation finalized) will greatly impact the co-investment vehicle structure to be implemented and, possibly, the types of investors who may invest.
• What will the appropriate structure be and what documentation will be needed? Given the time constraints often associated with co-investments, in most cases the co-investment vehicle for U.S. taxable persons will be established as a limited liability company or a limited partnership and, if there is an offshore fund, the offshore fund will “feed” into the U.S. fund (which effectively will act as the master fund to the offshore fund). Because most co-investment vehicle offerings pursue specific opportunities on an expedited basis, in most cases the manager will use a detailed term sheet rather than the full set of offering documents typically used for a private fund. The term sheet describes the investment and the co-investment vehicle’s material terms and considerations, including relevant risks and tax and ERISA considerations. Note that in cases where a manager foresees more than one co-investment opportunity, a “pledge fund” structure may be established to access more efficiently the various opportunities.
• What additional information (if any) will be shared with prospective investors? As noted, managers typically create co-investment vehicles to pursue discrete investment opportunities they have identified. Managers may want to share research, due diligence and other work product (e.g., projections, models, etc.) relating to the opportunity with prospective investors. At times, this information may include confidential information received from a target company. Before sharing this information, managers need to consider carefully any liability issues (e.g., the manager believes the information is reasonable but does not guarantee it, or similar limitations), contractual limitations under non-disclosure agreements, and, where applicable, potential insider trading concerns. Also, if the investment is a public company, the manager may not wish to disclose the target’s name to the investor base to preserve the ability to establish the position.
• Will the co-investment vehicle have a different general partner and/or investment manager than the flagship hedge fund? The co-investment vehicle will typically have the same investment manager, since that entity usually provides the personnel and overhead, and is often already SEC-registered. However, the co-investment vehicle may have a different general partner (which will receive the carried interest) than the flagship hedge fund, in order to insulate the flagship hedge fund general partner from liability and to better handle different compensation arrangements for firm personnel.
• How will investment opportunities and expenses be allocated? The use of co-investment vehicles and their related conflicts of interest have been identified by senior SEC personnel as high profile areas of concern. In particular, the manager should have written policies to address the allocation of investment opportunities among the co-investment vehicle and its main funds and other clients. A related point is that the manager should also have written policies addressing the allocation of expenses by and among the manager, the co-investment vehicle and its other clients. There may be circumstances in which the co-investment vehicle will reimburse the manager’s other clients for expenses that had been previously incurred. In addition, the manager will need to consider and disclose to all clients how “broken deal” expenses are handled. The SEC and its examination staff will also expect a manager to have documentation to support the determinations made in these areas.
• How will positions be valued? With respect to public investments, the manager typically will utilize the same valuation principles as it uses for its other clients. With regard to private investments, the manager will need to determine fair value in accordance with valuation procedures that may require the use of third party valuation agents.
• What will the likely investment holding period be? The anticipated holding period will impact the type of structure to be implemented, the form of compensation going to the manager, and when, if ever, will liquidity be afforded to investors.
• Will investors have any right to liquidity? Unlike in hedge funds, generally investors will not be permitted to voluntarily withdraw from the co-investment vehicle; however, the manager will typically reserve the right for itself to affect a mandatory redemption of investors (with or without cause). Typically, distributions will only be made upon a realization event.
• How will investor contributions be made? Many co-investment vehicles have drawdown mechanisms tied to capital commitments (similar to private equity funds), while others require all capital to be contributed on day one. The former creates some more administrative challenges, especially when the investment needs to be made quickly.
• Will the manager receive incentive compensation? The manager typically will only be entitled to “carried interest” incentive compensation (if any) once the investment is realized (often through a distribution waterfall, as is common in private equity funds) irrespective of whether the investment is public or private in nature. Moreover, it’s not uncommon for the distribution waterfall to include a preferred return (i.e., a hurdle rate) that the investor must receive before the manager is paid its incentive compensation. Managers will also need to determine whether all co-investors (including insiders) will be subject to the incentive compensation and provide adequate disclosure to existing clients and investors. If an investor in a co-investment vehicle also has an investment in another private fund managed by the manager, some managers have agreed to net the returns of both investments when calculating the incentive compensation.
• What management fees will be paid to the manager? The management fees charged by co-investment vehicles often are lower than those paid in the flagship fund, and it is not uncommon for the manager to receive no management fee. This is due in part to the fact that the co-investment vehicle is making one or a limited number of investments which often reduces the ongoing work and research required by the manager. Also, managers will need to determine whether all co-investors (including insiders) will be subject to the management fee.

If you have any questions concerning the establishment or ongoing operation of co-investment vehicles, please contact your primary attorney in Seward & Kissel’s Investment Management, Private Equity or Tax Groups.