In line with investor demand, hedge fund managers have been increasingly utilizing co-investment vehicles, structures traditionally associated with the private equity industry. Co-investment vehicles are typically used to participate in single (“best idea”) investments, usually alongside a manager’s “main fund.” Co-investment vehicles not only offer hedge fund managers an opportunity to meet investor demand and build relationships, but also to invest in less liquid assets or different strategies than may be permitted under their main fund’s investment strategy, to further invest in an attractive opportunity when their main fund has reached capacity, to create a track record with another vehicle, and to offer more products to differentiate themselves. Below we will address some of the various considerations in raising co-investment vehicles, including (i) structuring, (ii) key terms, (iii) offering issues and (iv) other conflicts and regulatory issues.

Structure

One standard co-investment structure is an “one-off” Delaware or Cayman Islands limited partnership (LP) or limited liability company (LLC). However, if a manger is expecting to participate in numerous co-investment opportunities with different investors, then this structure, which requires a new entity and related documentation for each separate investment, can create an administrative burden.

An alternative structure is a Delaware Series LLC or Cayman Islands segregated portfolio company (collectively, “Series Structures”), which allows a manager to simply create a new series within the same entity for each new co-investment opportunity. Under Delaware and Cayman Islands law, each series/portfolio in these Series Structures is treated as a separate legal entity, so the assets and liabilities of each series/portfolio are segregated from the assets and liabilities of other series/portfolios.¹ No formation filings are required to create a new series in a Series Structure, however, because each series is treated as a separate legal entity, there are regulatory and administrative requirements associated with each new series, as managers generally make separate tax (e.g., EIN), Form D and blue sky filings etc. for each series. Thus, while a Series Structure is beneficial because the actual entity and framework (e.g., term sheet with the core terms) is already established, the time and cost savings are not as great as may initially appear.

A manager can always just add a series or class to an LP or LLC (without utilizing a Series Structure) for each subsequent investment it makes, but if there are different investors participating in different investments this may be unattractive to investors because they would potentially have exposure to the liabilities of other series/classes/assets (unless, for example, the different series/classes just hold different tranches of shares of the same company).

Another alternative is to have a co-investor invest directly in the asset and potentially give a proxy or power of attorney to the manager. However, this is more common in the private equity context where managers sometimes need co-investors in order to consummate a deal.

Key Terms

Co-investment vehicles often use certain private equity style terms since underlying assets tend to be less liquid and harder to value. For example, the term of a co-investment vehicle holding an illiquid asset will often match the life of that investment, and investors will usually have limited (or no) withdrawal rights.

Additionally, the incentive allocation will often be a private equity style waterfall, where carried interest distributions are made upon the disposition of the asset, with or without a preferred return to investors.

Management fees rates are often lower than rates charged by a manager’s main fund(s), and managers sometimes waive management fees altogether (especially if co-investors are investors in the main fund). Management fees can be calculated based on net asset value, but sometimes, because of the hard to value nature of an illiquid co-investment asset, they are based on the lower of cost and net asset value.

When a co-investment asset has reduced liquidity or is restricted, managers must also use alternative means to “pay” for the management fee, such as setting up “reserves” funded by initial contributions or using capital calls which would force investors to make additional contributions to cover management fees. Similar issues arise in paying ongoing expenses, and the foregoing solutions (reserves or capital calls) can also be utilized to cover expenses.

Offering and Selecting Co-Investors

An early stage decision, along with structure and terms, is to consider who will be offered the opportunity to participate in the investment. Managers often offer co-investment opportunities to investors in an existing main fund, but may also approach third parties depending on the size of the co-investment opportunity, the investors’ level of sophistication and ability to act quickly, the manager’s desire to build a relationship with and/or attract certain investors, tax/regulatory or legal considerations and other concerns such as side letter arrangements.

The offering of co-investment opportunities can raise fiduciary concerns along with issues of favoritism and conflicts of interest. This has been an area of particular focus for the Securities and Exchange Commission (SEC), which has specifically cited co-investment allocations as an example of favoritism and noted that “Rule 206(4)-8 of the Investment Advisers Act of 1940, as amended (1940 Act), and other antifraud provisions might be violated without adequate disclosure.”² The SEC has recommended that managers let investors know when, and on what basis, co-investment opportunities will be offered, so that investors are able to “complain” about a manager’s process.³

Importantly, the SEC has not required managers to allocate co-investment opportunities among investors pro rata or in any particular manner, but rather to carefully disclose to investors “where they stand in the co-investment priority stack.”⁴ Based on this guidance, standard practice is to establish a co-investment allocation policy (listing factors a manger will consider when making allocations) and include detailed disclosure on such policy in the fund documents.

Other Conflicts and Regulatory Issues

Expense allocation also raises conflicts of interest concerns, but, similar to the conflict discussed above, can generally be cleansed through a formal policy and sufficient disclosure. For example, when expenses relate to an investment held by both a main fund and a co-investment vehicle, especially broken deal expenses, the default rule is to allocate expenses pro rata (or, if a co-investment vehicle’s operative documents do not permit certain expenses, have the manager bear the vehicle’s pro rata share of such expenses). However, a manager should be able to allocate in a different manner so long as it is sufficiently disclosed to investors.

Managers that are registered investment advisers (RIAs) should also be aware of certain additional regulatory considerations. Co-investment vehicles are typically considered “clients”, so an RIA will generally need to disclose these vehicles on its Form ADV. Furthermore, an RIA must comply with the Custody Rule (Rule 206(4)-2 under the 1940 Act), including the requirement for the vehicle to undergo an annual audit (or otherwise be subject to surprise examination).

Final Thoughts

While certain elements of co-investment vehicles mirror those of traditional hedge funds, there are many unique issues and considerations that managers need to address, including unique conflicts, not all of which are covered in this article. In addition, given the often bespoke nature of co-investment opportunities, assets and participants, it is not clear that “market” terms will develop for co-investment vehicles in the same way they often do for traditional hedge funds. The issues discussed above regarding options for structuring co-investment vehicles, negotiating key terms, offering and selecting co-investors, conflicts of interests and regulatory considerations should therefore be considered carefully with respect to any new co-investment opportunity. Managers are encouraged to consult with their tax and legal advisers throughout the co-investment process.

Footnotes

_{1. Note, however, that there is little to no precedent available on the treatment of Series Structures by Delaware, Cayman Islands and other foreign courts, so there is no guarantee that such segregation would be upheld in all instances.}

<sub>2. https://www.sec.gov/news/otherwebcasts/2014/complianceoutreachns013014.shtml

3. See FN 2.</sub>

_{4. https://www.sec.gov/news/speech/private-equity-look-back-and-glimpse-ahead.html}