The term co-investment is a pretty broad one. I consider it to include any situations in which LPs take additional stakes in portfolio companies that they are already indirectly invested in through their investments in venture capital funds. On one end of the spectrum, this might be by way of a GP making a simple introduction of one of its LPs to a portfolio company, followed by the LP negotiating directly with the portfolio company to acquire shares. Here the fund manager’s involvement is limited to that introduction, and it usually gets no direct economic benefit. If the company does well, it’s a way for the LP to “blend down” the carry and expense drag on the position, and for the GP to have assisted in a way which helps the LP and is thus favorable to the overall relationship. There are strong reasons for GPs to engage in this sort of informal co-investment matchmaking, and many do so very regularly, today included. On the other end of the spectrum, GPs sometimes take a more active role in managing co-investments by establishing and managing one or more entities through which co-investments are consummated. This post focuses on these sort of vehicles and especially changes in the last few years.
During that time, there has been an evolution in the trendline of what happens with the sort of “overage opportunities” that can lead to chances for co-investment. By “overage opportunities” I mean stakes in venture backed private companies, usually in later rounds, that exceed the fund’s ability to do the entirety of the available position, whether by reason of single-deal limits or, of lesser amount, the GP’s view of what is a prudent maximum stake for the fund to take given diversification and other factors.
In my estimation, these most current trends arose in response to the unicorn phenomenon – more companies staying private, much longer than in the recent past, raising more and larger rounds, in turn requiring more capital to continue with the company to exit than historically. A number of venture fund clients I work with seem to have an understandable strong desire to “stay with the company”. The view I hear a lot is, “why would I let other funds, even hedge funds, or corporate investors, come in late and make the last gains, where we were the ones to identify the company and nurture it to where it is?” A correlated proposition is often that LPs should back the VC on these deals, given the VC’s deep understanding of the company and market sector in question.
For better or worse, indisputably, in the recent past there have been a ton of SPVs (to do single deals) or even aggregated “top up” vehicles (to do multiple deals). The top up funds take many varieties, some are pass the hat vehicles where the basic economic structure is set up front but LPs maintain discretion to bow in or out of various deals as they elect in real time; others are true discretionary pools where the GP has the ability to deploy the capital in deals it chooses, though often subject to pre-negotiated ground rules (for example, limiting the capital to deals originating from one or more particular underlying funds; single deal limits; requirements that underlying funds have reached certain thresholds like putting in some amount of capital before a deal can be considered by the “top up” fund, advisory committee approvals, and so forth).
So, how does a GP go about establishing these sorts of programs? The first key is to make certain that the underlying main fund LPA permits this type of undertaking. This includes close watch of the “presentment” obligation, if any, as well as attention to the team members’ time commitments and ability to raise other managed vehicles.
A presentment clause, sometimes but not always seen in deals, is a fund manager’s obligation, usually through the LPA, to bring deals for first look, or even first option, to the main fund in question. Historically, these clauses have been fairly permissive in allowing the GP to offer opportunities to others, and in fact, the VC industry is really built on this: a tight presentment clause that served to restrict syndication of deals to other VCs could be viewed as unhealthy in terms of maintaining deal flow networks; likewise, the inability to give a piece of a deal to a particular party that might be of strategic benefit to the underlying portfolio company would also be less than ideal (this could even be an LP – think of Qualcomm’s ability to use its own networks to help an IT start up, etc.). However, these days, its worth taking a very hard look at this language if you desire to have the ability, now or in the future, to run some sort of “overage opportunity” program. Beyond presentment, one need be aware of time commitment clauses (which may restrict the investment professionals’ ability to manage other vehicles) and even successor fund clauses (which may restrict ability to legally organize the co-investment entity itself).
A typical, broad permissive clause might allow the fund manager to: “organize, manage and devote time to one or more co-investment vehicles to invest in co-investment opportunities of the fund” with co-investment opportunity defined as “an opportunity to invest in a portfolio company concurrently with the fund or to make an investment in a follow-on investment opportunity in a portfolio company where the fund is not investing (in each case, to the extent of and dependent upon there being available excess capacity following a determination by the fund manager of the fund’s participation).”
Beyond making sure that current arrangements permit the fund manager to establish some sort of “overage opportunity” program, I am frequently asked about market terms for these deals. This is a tough question to answer in generalizations, because the terms of these sorts of vehicles varies widely in my experience. On the one hand, I have seen some fund managers who run these sort of entities (particularly single-deal SPVs) at no charge, though this is in a significant minority of deals. On the other hand, I have seen these sort of entities that have both full freight fee and carry attached (particularly aggregated funds doing multiple deals).
I would say the usual deal I see, particularly for aggregated funds doing multiple deals, though often for SPVs as well, would be for full carry matching that of the underlying main fund, and either no management fee or a small fee significantly reduced below the management fee charged by the main fund. This sort of deal seems to align interests as I would see it: on the one hand, the alignment of interest inherent in the carried interest relationship is preserved, while at the same time fee drag is eliminated or significantly reduced in light of the fact, true for sure, that there really is not much more work, if almost any, associated with these deals. That is to say, the fund manager doesn’t need to source these deals, it doesn’t need any different exit strategy (exits are usually contracted between the vehicles as same time, same terms), and it usually doesn’t need to devote additional resources (the deal is being monitored already, someone is on the board or not on the board already, etc.). If these facts vary in your situation, the deal may vary – but these facts are the ordinary ones. I also see deals that are close to this but play around the edges of it – maybe a main fund 25% premium carry, or a ratcheted 20-25% carry, is 20% flat in the overage entity; etc.
Until there is a significant change in the industry, I am urging my clients to strongly consider setting up LPAs in funds being raised now to accommodate the current or future ability to run an “overage opportunity” program. LPs for their part seem to look on this fairly favorably these days.