The demand for co-investment rights – the ability to invest alongside a blind pool vehicle – has emerged as a clear and growing trend in the private equity real estate space, as the largest institutional investors seek to deploy capital into unique opportunities. We are seeing an increase not only in the negotiation of co-investment rights in real estate fund documents, but also in the number of transactions that actually utilize co-investment capital. In light of such activity, fund managers need to be ready.
From an investor’s perspective, co-investment rights are attractive because they are often accompanied by increased transparency and control over an investment, as well as more investor-friendly economics. At a minimum, an investor’s overall blended fee on its invested capital is reduced by avoiding the payment of fees on committed capital for amounts ultimately deployed as co-investment, and frequently a lower percentage fee is applied to contributed co-investment capital.
Certain investors may even decide to commit to a blind pool vehicle solely to obtain co-investment rights because they believe that these rights will provide them with the chance to devote greater capital to better investment opportunities identified by the fund sponsor, as well as insights about fund managers’ views on these opportunities.
From a fund manager’s perspective, co-investments often lead to larger investor commitments and in turn can increase assets under management and provide exposure to investment opportunities that may not otherwise be available to the fund. In addition, co-investment opportunities can further align an investor and a sponsor, fostering a closer relationship for future endeavors.
However, co-investments do come with their own set of challenges for fund sponsors, including lower compensation on co-investment capital, increased administrative burdens and co-investment allocation issues and demands among multiple investors. Fund sponsors are often willing to grant co-investment rights in principle, but then must grapple with the reality of administering the process of offering co-investment rights for particular investment opportunities that does not interfere with the ability to execute the transaction efficiently. They are also becoming increasingly wary of the perception among institutional investors that co-investment rights should come with bargain management fees and reduced incentive fees, carried interest or promote.
Co-investment mechanics are also evolving. Where co-investment rights are offered to all limited partners, the offering mechanics are explicitly addressed in the fund’s partnership agreement, with opportunities generally presented to investors on a pro rata basis in accordance with their capital commitments. In other cases, sponsors may agree by side letter to provide one or more investors with a preferential share of co-investment opportunities. In particular, a fund sponsor may seek to incentivize investors to commit to the blind pool fund by offering priority co-invest rights to certain tranches of investors, such as first closers or larger commitment fund investors, with an opportunity only becoming available to other tranches if the priority tranche has passed.
In situations with known co-investment opportunities, investors will often seek to incorporate the terms of any co-investment arrangements, including any reduced fees, into the existing fund documents, with varying levels of success. In other instances, limited partners and managers may negotiate form documents in advance to be utilized for any co-investment opportunity. This is particularly useful in addressing the manager’s objective of efficient execution, as it gives co-investors the option to co-invest in a deal without the often time-consuming and burdensome step of negotiating legal documents to govern the particular co-investment arrangement.
The terms of any co-investment arrangement and the level of investor involvement in decision-making can also vary. However, most investors tend to focus on information rights and economics, as well as on greater control over any potential additional funding that a co-investment may require.
While there is no consensus yet on 'market' terms for co-investment arrangements, there is a growing sentiment in the private equity real estate space that co-investment rights are here to stay and will be increasingly employed. Sponsors should expect these requests and prepare accordingly.