Private equity and co-investment rights

Introduction

In the competitive landscape for private equity investments and the challenges of raising funds, “co-investing” has become a very important aspect for both investors and managers of private equity funds.

This article provides a brief overview of co-investment rights in Dutch private equity and will be concluded with some recommendations.


What are co-investment rights?

Co-investment rights are rights granted by a private equity fund to an investor to co-invest – together with the fund itself – in new business opportunities, targeted by the fund. Typically, co-investment rights are offered to leading fund investors and managers of private equity firms. According to a survey the main reason for investors to co-invest in certain opportunities is the prospect of greater returns and lower fees as most fund managers charge lower management fees and carried interest on co-investment arrangements, or charge no fees at all. The fund managers on the other hand feel offering co-investing rights is important during fundraising. Other reasons for offering co-investment rights are to build relationships with the investors for future funds and to derive certain strategic benefits, for instance by being able to make use of co-investors’ network, skills and to share future deal-sourcing opportunities. From the same survey is has become clear that half of the 222 investors surveyed (worldwide) are either actively or opportunistically co-investing.


The opportunity arises… invoking your co-investment right

In the event the fund manager becomes aware of a possible interesting business opportunity, he will need to inform its investors thereof. That way, the investor will be in a position to evaluate the opportunity himself, conduct due diligence and arrange for capital on short notice to complete the investment. When a co-investment opportunity is identified, the parties generally need to act fast. Deal-documents are often presented to co-investors on a ‘take-it-or-leave-it-basis’. Nevertheless the co-investor should be able to ask questions and express concerns. This field of tension is considered by most fund managers to be the downside of co-investment rights as it delays the deal process. To reduce the risk of losing momentum, the fund managers often offer co-investment rights limited with clauses on timing regarding acceptance and closing of a co-investment opportunity. In a striking case, brought before a Dutch district court several years ago, an investor sued an investment fund for not having offered the investor the possibility to co-invest. From the ruling several lessons can be learned for investors and fund managers. What was the case about?


D-Age vs. Nethave

In 1999 investment fund D-Age committed itself to invest EUR 5 million in private equity fund Nethave, a 100% subsidiary of Greenfield Capital Partners. In addition, one of D-Age’s indirect shareholders and indirect directors would make his expertise available to Nethave and would also be appointed as one of the members of Nethave’s investment committee. In exchange D-Age was granted with a co-investment right that would enable D-Age to participate for 25% in any future investments of Nethave. In the ensuing period from 2002 – 2005 Nethave made four – very successful – investments with a total net income of over EUR 411 million (one of the investments concerned telephone company Telfort). According to D-Age, Nethave never offered D-Age to co-invest and initiated legal proceedings in which it claimed 25% of said amount, i.e. EUR 102 million.

Based on the Dutch law tenet of ‘reasonableness and fairness’ the court rejected D-Age’s claims that concerned three of the four investments. Reason was that D-Age’s indirect shareholder and director, in his capacity of member of the investment committee of Nethave, was fully aware of the envisioned investments, yet D-Age invoked its co-investment right only several months after the transactions had been closed; this would mean that D-Age would benefit from the investment made by Nethave without having taken any risks, which is, according to the court, unacceptable to standards of reasonableness and fairness. D-Age had more success with the fourth investment (Canal+), since only one day after this investment had been evaluated by Nethave, D-Age informed that it would also like to consider investing. In short, the court declared that Nethave, by not having offered D-Age the opportunity to co-invest, failed to perform its contractual obligation towards D-Age and ordered Nethave to pay EUR 18.2 million in damages.


Conclusion and recommendations

Co-investments rights have taken a dominant position in the competitive landscape for private equity. Under Dutch law, funds and their investors may agree on a co-investment right with such limitations in time and thresholds as they deem prudent, taking into account that deals generally should be closed fast. Finally, providing the information of new business opportunities as soon as they arise is imperative. If an investor is aware, does nothing and then claims part of the net result, it is likely that a court will reject this claim based on standards of reasonableness and fairness.