LPs want protections from continuation funds for their ‘no fee’ co-investments

Co-investing limited partners are increasingly asking GPs to ensure their often no-fee, no-carried interest co-investments won’t be “dragged” into a continuation fund that would charge them new fees, sources told affiliate title Buyouts.

The request, which has been emerging with the explosive popularity of GP-led continuation funds, is among several measures LPs are demanding in the tougher fundraising markets. With sluggish fundraising and GPs often desperate for capital, LPs are in a stronger position to demand certain concessions that may have been unworkable in the bull market years.

The co-invest/continuation fund conundrum is just one of several issues LPs have homed in on to try and reverse what they see as GP overreach when fundraising was soaring.

“It’s almost like watching this collision of two concepts. As an LP, I’m co-investing because I want more capital invested at a slightly cheaper price, but as an LP I also want liquidity. In comes the continuation fund and I may get dragged into it. I wanted liquidity but I don’t want it like that,” said Andrea Auerbach, head of global private investments at Cambridge Associates. “I would say GPs face an interesting tension.”

For co-investing LPs, the bottom line is the emergence of a potential tough choice years after they entered a promising investment alongside a GP. Co-investing is mostly offered free of management fees or carried interest for LPs, with the only fees paid by the portfolio company back to the GP.

While once ubiquitous, no-fee, no-carry co-investing is still the market standard, though fees and carry have started to creep into co-investments in recent years, sources said.

LPs have become concerned that in the future, they may be offered the choice between selling the co-investment at a potential discount, or rolling their interest into a continuation fund, which comes with its own management fee and carry rate. Suddenly that “free” co-investment got a bit more expensive.

Not just about fees

It’s not only the potential for future costs that have LPs worried. Other issues involved with continuation funds could crop up, according to Isabel Dische, chair of the alternative assets opportunity group at law firm Ropes & Gray.

“Now that there’s been a GP-led transaction, the tenor of the investment and how long that investment is going to be held gets extended. Your relationship with the sponsor may have soured over that period of time, so you may not like the new time horizon. Or there may have been changes with the asset,” she said.

Some co-investors are happy to simply cash out, and some LPAs default to automatically cashing out co-investors in continuation fund situations, sources said. Though it’s not one-size-fits-all, Dische said, as some co-investing LPs want the option to sell or roll as well as the right to greenlight the continuation fund deal, just like fund LPs.

For some co-investors, “it’s not enough that the underlying fund alongside which we’re co-investing has approved the GP-led transaction, if it’s touching our asset we need approval rights as well”, Dische said.

Co-investors who want the option to roll also generally want it to be on the same terms as they had through the original investment, she said. And some co-investors by policy aren’t allowed to roll into a new vehicle.

“There’s a menu of ways we’ve seen investors approach GP-leds,” Dische said. “We’ve seen GP-led deals where sponsors forget about co-investors to some degree or don’t think they have to deal with them, and then have to scramble at the last minute.”

Some LPs regularly request side letters that explicitly prevent the co-investing LP from being dragged into a continuation fund, according to Kari Harris, chair of the investment funds practice at law firm Mintz. The LPs don’t always get the terms, but they definitely ask.

“There’s more of an awareness now” among LPs, Harris said.

More common

LP concerns have increased as co-investments proliferate and increasingly become part of the secondaries mix.

Co-investments have become an integral part of the GP-LP relationship. Raymond James found that 72 percent of LP respondents to its recent summer market survey said the availability of co-investment opportunities is a key factor when considering a GP relationship.

Co-investments have not always been a big part of LP sales, but have started to show up in LP portfolios in recent years. Now they are sometimes the entire focus of a sale. CPP Investments, for example, was selling a basket of co-investments valued at around $1 billion this year in a process that was eventually pulled because of pricing.

And Apollo’s new private equity secondaries group, named S3, is lead investor on a deal that would move around 50 co-investments out of older GoldPoint Partners funds and into a continuation fund, Buyouts reported in July.

LPs also complain that in recent years GPs have generally been asking for broader and more sponsor-friendly terms that, in many cases, LPs have to accept to get into a desired fund.

“We have seen a few funds get aggressive with main fund LPA terms that say they can force LPs into continuation vehicles. We have said absolutely not and have successfully removed these provisions when we see them in LPAs,” said a large public pension LP.

“It feels like a constant battle pushing back on grossly one-sided LPA terms lately. Even with the difficult fundraising environment these types of silly terms find their way into draft agreements,” the LP said.