Despite the COVID-19 pandemic, dealmaking activity has remained robust.
This includes transactions coming out of co-investments, which have also remained an attractive opportunity for co-investors to increase their private equity exposure on a reduced fee/carry basis as sponsors look to attract additional capital to access larger deals. In this article, we discuss issues we are encountering with some frequency now in the co-investment market in Canada and the U.S., including the impact of continuation funds and the possibility of an exit to a SPAC.
Over the past several years, private equity sponsors have been increasingly pursuing continuation funds as a successful portfolio management tool. In a continuation fund, a sponsor transfers one or more portfolio companies from its existing fund to a new special purpose vehicle. Fund investors are often given the option to reinvest the proceeds from, or roll, their interest in the portfolio companies into the continuation fund or to receive cash for their interest in the portfolio companies, which is provided by new investors in the continuation fund.
Co-investors generally seek to be aligned with a sponsor’s primary fund with respect to all liquidity events—exiting at the same time and on the same terms and conditions as the sponsor’s primary fund.
However, many co-investment vehicles’ limited partnership agreements (LPAs) provide for a carve-out to this general alignment provision for transfers by the sponsor’s primary fund to its affiliates.
Some LPAs broadly define an affiliate transfer in a manner that allows the sponsor’s primary fund to transfer its interest in the portfolio company to any fund managed by the sponsor or its affiliates, which would include a continuation fund. The upshot is that the alignment provisions in those LPAs don’t apply in the context of a transfer to a continuation fund. Given the recent proliferation of continuation funds, investors are increasingly focused on these provisions in LPAs and may seek to specifically address continuation funds in the LPA.
We have seen co-investors take different approaches to this issue:
Some co-investors take the position that transfers to a continuation fund should not constitute an affiliate transfer and should remain subject to the general alignment principles that otherwise govern exits by the sponsor’s primary fund (i.e., co-investors should participate in these transfers on the same terms and conditions as the sponsor’s primary fund). Some sponsors are amenable to this; others push back.
Other co-investors are comfortable with the sponsor’s primary fund transferring its interest to a continuation fund without triggering liquidity options for co-investors (especially so long as the proceeds of such transfer are not cash). These co-investors are of the view that a continuation fund transfer (where one vehicle managed by a sponsor is selling to another vehicle managed by the same sponsor) could lead to a lower price for the portfolio company than could be received in a sale to a third party. Accordingly, they prefer “sitting out” the continuation fund transfer for potentially greater rewards (i.e., third-party sale) down the road. However, it should be noted that not all co-investors share the concerns regarding conflicts and price; arguably, these concerns are at least in part mitigated through validation of the transfer price by independent valuations and through participation of new third-party investors in the continuation fund.
Yet other co-investors take the position that they should receive the same option as that provided to the investors in the sponsor’s primary fund (e.g., if fund LPs have the option to roll their interest into the continuation fund or to receive cash, co-investors should be provided with the same option).
Since the objective of the continuation fund is to allow the sponsor to continue managing the portfolio company beyond the life of the primary fund, if the alignment provisions do not apply to a transfer to a continuation fund, co-investors should be aware that this can have the corollary effect of extending the term of the co-investment vehicle. Co-investors should also ensure that, following any transfer to a continuation fund, the general alignment principles apply to a subsequent transfer of the portfolio company by the continuation fund.
This continuation fund issue is particularly prevalent in the U.S. market where the secondary market is more mature, leading to more continuation funds there as compared to Canada. Canadian co-investors are more likely to encounter this issue when investing with U.S. sponsors than they are when co-investing in Canada—although as continuation funds begin to catch on in Canada as well, this issue is increasingly on the minds of Canadian domestic co-investors.
SPACs and other IPOs
The seemingly unstoppable momentum of the Special Purpose Acquisition Company (SPAC) has arguably increased the likelihood of a capital market exit for many investments, which brings into renewed focus how co-investment agreements operate in connection with a capital market exit.
In most cases, the general alignment principles will apply to a sale of a portfolio company to a SPAC. Accordingly, co-investors will participate in the sale at the same time and on the same terms as the sponsor’s primary fund, receiving either cash or publicly traded shares of the SPAC.
Additionally, co-investment LPAs that specifically contemplate the possibility of an IPO often give the sponsor flexibility to distribute public company shares to co-investors or to hold those shares in the co-investment vehicle and then determine when to sell those and distribute the proceeds to co-investors. (We expect to see that this optionality may be extended to the publicly traded shares of SPACs). Depending on their internal set-up and monitoring abilities, co-investors may prefer one approach over the other and, where that is the case, should make sure the co-invest LPA reflects their preference.
In any event, co-investors (whether directly or through the co-invest LPA) should be sure to receive piggyback registration rights on sales by the sponsor of public company shares in a SPAC or in an IPO corporation. Co-investors should also consider if they want to remain aligned with a sponsor in the (less likely) scenario of a private sale of public securities by the sponsor.
As with continuation funds, SPACs are much more common in the U.S. than they are in Canada, so Canadian co-investors are more likely to be faced with these considerations when they are investing with U.S. sponsors than they are when co-investing domestically.
We have increasingly seen concerns from co-investors over the disclosure of material non-public information (MNPI) by sponsors as part of their reporting package to co-investors, especially for co-investors with diverse investment activity that includes a debt or credit group. Those co-investors are often sensitive to receiving MNPI as it could preclude them from trading public debt issued by the portfolio company or related entities. Ideally, co-investors are given the option not to be provided with MNPI so that the co-investment activity doesn’t taint the activities of other groups within an organization. This is typically addressed in their side letter.
Key takeaways for co-investors
As continuation funds become increasingly prevalent, co-investors should consider how the alignment principles should apply to transfers of a portfolio company to a continuation fund.
Co-investors generally participate in sales to SPACs at the same time and on the same terms as a sponsor’s primary fund. However, the prospect of an exit to a SPAC brings new focus to co-investor alignment in connection with (and following) a capital markets exit of a co-investment.
Co-investors, particularly those with a debt or credit group, will want to continue to be mindful of receiving MNPI as part of their co-investment reporting package.