Increasingly, hedge funds are emulating their private equity counterparts by making what are commonly referred to as “co-investments.” Occasionally, a hedge fund manager will come across an attractive investment opportunity that is either inappropriate for its fund or too large to allocate solely to the fund. In that case, the manager may seek to invest in that opportunity outside of the fund through a separate account, special purpose vehicle or other structure (a “co-investment vehicle”), and solicit investors to invest in that vehicle.
There are a number of reasons why a manager may choose to set up a co-investment vehicle. For example, the manager may like the opportunity but believe that it is too big to allocate solely to its hedge fund (or that it does not fit the fund’s strategy, risk parameters, liquidity profile, etc.). The manager may believe that a co-investment vehicle will facilitate a larger investment that could engender good will with the company, improve deal terms and future investment opportunities, or attract/benefit its existing fund investors by offering them a special opportunity. Or, the opportunity may require an investment of a certain size and the manager may not be able to meet that size requirement with the hedge fund alone.
Often the manager will offer a co-investment opportunity to a limited group of its current investors. For example, the manager may focus on investors who can respond quickly, are highly sophisticated and able to bear the risks of a concentrated, illiquid investment, or who are large investors in the manager’s current fund. The manager also may be limited by the need to keep the opportunity confidential.
Before making a co-investment, the manager should consider, among other things:
• Structure. Occasionally, a hedge fund structure may permit a side pocket or separate series to accommodate a co-investment. Often, however, the manager establishes a separate co-investment vehicle to invest in the target. Co-investors would then invest in that vehicle. The fund, if participating in the co-investment opportunity, would usually invest alongside the co-investment vehicle. Alternatively, co-investors might invest directly in the company alongside the fund, subject to a voting rights agreement or other agreement.
• Documentation. Typically, a co-investment vehicle set up as a separate entity would have a governing document, such as a limited liability company or partnership agreement. The manager also may prepare an offering circular detailing the terms of the offering and the specific risks relating to the investment. This offering circular might take the form of a short-form wrapper, for example, if investors are sophisticated and have substantial access to deal documents like a term sheet. Often a subscription agreement will have the investor acknowledge its sophistication and some of the deal risks. If a manager expects to have numerous co-investment opportunities, it may choose instead to establish a single special purpose vehicle to handle multiple co-investments, in which case, there might be a single offering circular explaining the overall structure, then an individual “wrapper” or supplemental disclosure for each deal. If a co-investor is actively involved in negotiating the deal alongside the manager, the parties may determine that a disclosure document, such as an offering circular, is unnecessary.
• Conflicts of Interest. The hedge fund manager has a fiduciary obligation to its clients, including the hedge fund and its investors. The manager needs to consider carefully how it will fairly allocate opportunities among clients, as well as how it will handle liquidating a position across client accounts if sales cannot occur simultaneously. Often, expenses of a co-investment vehicle cannot be allocated pro rata. To the extent that the fund or another client bears a disproportionate share of those expenses, the manager will need to make sure that risk is adequately disclosed. For example, if a co-investment fails to materialize, the manager’s hedge fund may bear all of the expenses incurred to research/negotiate the opportunity that ultimately was not exploited (often referred to as “broken deal” expenses). The hedge fund investors should be advised of that risk. The manager also needs to consider the flow of information and whether, through the co-investment, the manager may acquire inside information about a public company that could adversely affect trading for the fund and other clients. With the co-investment, the fund might receive worse pricing or less advantageous terms than co-investors. The manager and its principals also may invest directly in the co-investment ahead (or in lieu) of other investors. The manager will need to consider these and other conflicts of interest, and tailor its disclosures and compliance policies and procedures accordingly
• Regulatory Issues. A co-investment vehicle, if set up as a separate entity, such as a partnership, limited liability company or corporation, must comply with the same regulatory requirements as the hedge fund. For example, the manager would need to ensure that the vehicle meets the requirements for exemption from registration under the Investment Company Act of 1940 and that sales of interests in the co-investment vehicle comply with federal and state securities laws. See Demystifying Private Placement Laws Part 1 and Part 2 for more information.
Managers contemplating a co-investment should consult with counsel to consider these and other issues.