Here are the pitfalls when allocators make direct deals or co-investments
In search of returns, asset owners are increasingly turning to co-investments – where they invest in companies alongside private equity firms or hedge funds – and direct transactions in the hope of higher returns. However, experts caution investors that these complex transactions present their own challenges.
Not only do asset owners benefit from these deals, but investment managers too, said Jennifer Post, partner at law firm Thompson Coburn. They can attract institutional capital to their funds by offering the opportunity to invest directly. “This allows them to leverage their capital base to run bigger businesses, gain market share and build a track record of growing assets under management,” said Post.
Although these investments promise high returns du jour, according to legal experts, investors must ensure that they have sufficient capacity to deal with their unique structure.
“These agreements come with complexities, challenges and regulatory issues that need to be carefully considered,” added Post.
Hartford HealthCare and Arizona’s Public Safety Personal Retirement System are two recent examples of institutions adding co-investment strategies to their portfolios, while the California State Teachers’ Retirement System signaled last year that it would shift its focus to direct business, similarly as has long been done with Canadian pension plans.
The challenge of an investment team starts with sourcing deals. Edward Tran, a partner at Katten Muchin Rosenman, said he recommends hiring an in-house team to find and conduct the due diligence required for these deals.
“Institutional investors need to be able to properly conduct commercial and legal due diligence,” said Tran, adding that this often requires referrers to hire people with new and varied skills and experience.
This is less critical in co-investment deals, as the asset managers, who offer the option, can perform some of the due diligence work required for decision-making.
When co-investing, allocators should consider the proportion of their capital they want to invest in the main fund as opposed to their ancillary obligations, Post said. “On the fund and co-investment side, there should be no variation in how the investment is managed,” she added. “We want to make sure that this is taken into account in the documentation.”
She added that investors need to determine their liquidity needs and risk tolerance in advance to ensure they are aligned with their managers and other allocators in the group.
“Conflicts can arise when [some in] the Co-Invest Group [have] Liquidity needs sooner or [have] a lower risk tolerance, “said Post. “You can put pressure on the manager or look for a less risky investment strategy.”
When structuring either co-investments or direct deals, institutions can require their managers to provide tailored or advanced reporting. Co-investors can also set the terms of follow-up pledges in their initial deal agreements, Post said.
A potential trap? Post said some investors want a guaranteed first look at all transactions in the main fund. However, this may not be realistic given the needs of the other investors in this main fund.
When it comes to direct business, while some of the same guidelines apply, there are different considerations for institutions to make.
According to a report released by Katten Muchin Rosenman in late July, investors should consider applying for a right of first refusal, which ensures they can keep the level of their stake even if the company seeks further funding. You can also apply for anti-dilution rights that allow the grantors to adjust the value of their shares in the target deal in the event that the company sells them at a lower price than they were purchased.
Investors can include scrutiny rights in their contract giving them the ability to add board members and veto certain business decisions, and should make arrangements to resolve deadlocks that address disagreements among a company’s many investors.
According to Post, direct and co-investment explosions are rare when there is adequate legal protection.
“I haven’t seen any catastrophic situations,” she said. “If things are well documented in advance, there shouldn’t be any problems.”