In recent years the Securities and Exchange Commission (“SEC”) has focused heavily on private equity firms. Perhaps more so than for other firms, the SEC is concerned about conflicts of interest, particularly regarding external co-investment: the leveraging of a primary fund’s diligence of a portfolio company to offer a secondary investment opportunity to limited partners or others. The incentives for such an investment include higher returns through lower fees in a portfolio company that has already been thoroughly examined.
The SEC’s main concerns regarding these transactions include:
- Whether the fund appropriately discloses to all limited partners how it selects co-investors from the pool of limited partners;
- Appropriate disclosure regarding allocation of costs for diligence and research among the primary funds and co-investment vehicles;
- The co-investment process must be consistent with the firm’s fiduciary duty to the primary fund(s);
- Funds’ offering documents, Form ADV disclosures and policies and procedures must appropriately discuss co-investment procedures.
As the KKR enforcement action made clear, firms must review (and upgrade, if needed) their policies and procedures around co-investment activities, including how they allocate research and deal costs. Firms should consider:
- Implementing clear policies and procedures outlining co-investment practices, including:
- When, how and to whom these opportunities will be presented;
- How broken deal expenses will be shared amongst the fund, co-investment vehicles, and the firm; and
- How co-investment fees are determined.
- Satisfying fiduciary duty obligations for the primary fund prior to making the deal available to co-investors;
- Documenting all parts of the investment process and involving the compliance team to monitor it; and
- Reviewing co-investment processes on an ongoing basis to ensure that they are executed in accordance with policies and procedures.
Legal counsel will likely be heavily involved in preparing the deal documents and should be consulted regarding the disclosure issues. Firms should also consider leveraging their compliance consulting team on policy matters and ongoing monitoring.