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3 Key Considerations For PE Co-Investment Transactions

Law360, New York (February 09, 2015, 10:13 AM ET) --

In the life cycle of a private equity-sponsored company, the company may require capital beyond what the private equity sponsor is willing or able to commit from its sponsored funds. Instead of accessing public markets or capital providers unfamiliar with the business, it may be more efficient for the private equity sponsor to seek co-investment capital from the limited partners of its existing sponsored funds. Further, the sponsor may have access to third parties interested in investing in the company. In this type of offering, if the company is issuing new securities to both the private equity fund and to a population of the fund’s limited partners or third-party investors making a concurrent investment alongside, but outside the fund, these investors are commonly said to be “co-investing” with the fund. This article provides a high-level analysis of key benefits of a co-investment transaction and also identifies three key issues to consider. Benefits of Co-Investment Transactions From the private equity sponsor’s perspective, a co-investment transaction can provide strategic capital — from rescue capital to growth capital — for a portfolio company without necessarily ceding control over the governance of the company to one or more new investors. This option may be particularly attractive to the sponsor once its fund that made the original investment in the company no longer has remaining capital commitments. In some cases, the private equity sponsor can earn management fees and carried interest for organizing and managing the additional investment outside the fund. Further, the sponsor may limit co-investment opportunities to limited partners who have made minimum capital commitments to its sponsored fund (so-called “most-favored-nations” investors). Accordingly, the sponsor may use co-investment opportunities to incentivize larger capital commitments to its funds, which may be particularly attractive to investors when markets are active and transactions are difficult to source. From the company’s perspective, if existing limited partners of the fund co-invest alongside the fund, the company can potentially close the capital round faster than if the company needed to raise capital from investors unfamiliar with the business — addressing the strategic needs for the capital on an

C. Spencer Johnson III

expedited basis. Further, if a co-investment transaction allows the company to avoid a change of control by accessing capital that is ultimately managed by the same private equity sponsor (though perhaps managed outside of the sponsor’s existing fund), then the company can potentially avoid the considerable disruptions to the business that follow a change of control. These disruptions may include assignment and other consent issues under commercial arrangements, consents and fees from lender groups, and the time-consuming process of renegotiating a new governance structure. Three Key Issues in Co-Investment Transactions Preemptive Rights The terms of any applicable preemptive rights represent a key consideration in any potential co-investment transaction as they may dictate how and to whom the securities may be sold. Co-investment transactions may require preemptive rights analysis at two (or more) levels. Before the operating company issues new securities to a group of co-investors, the company’s organizational documents will dictate whether the company’s existing equity holders are entitled to the first right to fund the company’s capital needs (or else waive their respective rights and be diluted). The private equity sponsor’s limited partnership agreement or other similar organizational agreement may separately dictate that if a portfolio company of the private equity sponsor requires financing above and beyond the sponsor’s capital commitment to the company, the general partner will give all or certain limited partners of the sponsor the opportunity to fund the required capital before third-party investors fund the required capital. In addition, if the initial terms of an offering change during the negotiation of the investment, the preemptive rights could “reload,” requiring the company and the sponsor to again offer preemptive rights on the basis of the new offering terms. There could be exceptions to these preemptive rights, including if the company decides to hire an investment bank or placement agent, to raise the required capital. Further, some sponsors permit only investors meeting “most-favored-nations” criteria to participate in co-investment transactions. Terms of New Securities Sold The terms of new securities issued by a portfolio company to co-investors will depend upon a number of factors, including the strategic need for the capital and company’s historical and projected earnings. Co-investors making investments in companies perceived to have riskier prospects often seek terms that simulate debt instruments through preferred equity securities that are senior to the common equity in the company. For example, co-investors may require regular, mandatory distributions of cash flow before any cash flow is available for distributions to common equity holders. These preferred securities also typically require preferred distributions over common equity holders until they receive an agreed rate of return. In addition, in order to provide additional upside to these preferred securities, co-investors typically require some additional common equity component to the transaction, which provides them with continuing participation in the common equity component of the capital stack once they have received their initial capital and preferred return. There are different ways to structure the equity component of these investments, but one structure would be to issue warrants to the co-investor that are exercisable during a given period of time for common equity in the company. Another approach, which is friendly from an administration standpoint,

is to issue an additional class of common equity units that participate in future distributions of the common equity. Investor Rights and Documentation Co-investors will often negotiate their investors’ rights package in a manner similar to any noncontrol investment, seeking restrictions on controlling investors adversely modifying the co-investors’ economic and other rights, exit protections and some level of governance visibility. The protection of economic and other rights typically come in the form of covenants and consent rights running in favor of the co-investor. Co-investors will typically seek a covenant from the company restricting the issuance of new securities that outrank the new securities sold to the co-investors either in terms of liquidation distributions or cash flow distributions in order to protect their core economics. Additional examples of these provisions include anti-dilution protection through preemptive rights in successive capital offerings, even if such offering are approved by the co-investors and covenants from the company on the size and terms of indebtedness that the company incurs during the period the co-investors hold securities in the company. These covenants also typically include a right for the co-investor to exit at the same time and in the same manner as the sponsor’s fund invested in the company. It is of critical importance in structuring these covenants that the company take into account its level of flexibility for future capital transactions and operating parameters in order to successfully run the business. The requested governance rights of co-investors will vary based on the strategic need for the capital — investors who view themselves as rescuing the company in general negotiate for more rights. Generally, co-investors seek to have a representative on the company’s governing body, either one with the right to vote or who is an observer. In addition, like any investor, co-investors will require periodic reports that contain financial statements of the company and management analysis of the business plan. It would be unusual for co-investors to seek control over operational decisions of the company, which are reserved to management and the company’s governing body; however, investors that perceive a need for their capital that would otherwise go unfulfilled are likely to push for specific consent rights over major decisions. These major decisions may range from acquisition transactions to key commercial contracts based on the needs of the company. Importantly, the scope and extent of the governance rights should be negotiated on a basis that takes into account potential change in control or other comparable relationships of the company, including commercial arrangements and debt documents. Conclusion As private equity sponsors and their portfolio companies seek capital, they may find that the sponsor’s institutional investors have a growing appetite for directly investing in portfolio companies alongside the sponsor’s fund. Sponsors can co-invest with these institutional investors to avoid potentially more expensive third-party capital, keep control over the portfolio company, and avoid a long diligence process with a new investor not familiar with the business. In negotiating these arrangements, the sponsor should be mindful of existing relationships and contractual arrangements that may place limits on the scope of the rights granted to the co-investors. —By C. Spencer Johnson III and Archie Fallon, King & Spalding LLP

Spencer Johnson is a partner in King & Spalding's Atlanta office. Archie Fallon is a senior associate in the firm's Houston, Texas, office. The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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