Hedge Fund Vista Webinar – 29 July 2020

Co-investment structures

Structure

A co-investment is a vehicle used to invest alongside the flagship fund in one investment, or a group of related investments under a single investment pool. These vehicles can have one or more investors that constitute the group investment. They are sometimes separate entities but can also be through, for example, an investment management agreement. There are certain factors that you should take into account when choosing which structure to use, including speed of execution, whether there is more than one investor intended for the vehicle, the desire of the investment manager to have control over the investment decisions that are being taken, tax and regulatory matters and the general investment infrastructure that is needed.

Investment infrastructure

Investment infrastructure means the range of factors that make up the structure of an investment vehicle. One of the things that we frequently find is that it is all incredibly urgent and it is important to find the quickest way to make the investment, and so using a pre-existing management agreement is often preferred.

Choice of entity

The choice of entity is a critical issue. When we see entities established, the most common first thought is to set up a Cayman SPC (an umbrella company), which can work but doesn't automatically reflect what is ultimately decided. We have seen the most common entity choice being a Cayman Limited Partnership. One of the reasons for this is that it is relatively quick to establish, and one of the benefits is that you can get access tax treaty benefits. Another tax consequence is the leverage, if there is leverage within the co-investment structure, which is not always the case, this could be a benefit in taking this approach. Clients are often also very interested in turning the co-investment into a single investor vehicle, that doesn't constitute an AIF, and where the constitutional documents limit the number of investors to a single investor, for the purpose of saving time. An interesting detail will be whether, if you are creating a Cayman entity, it can fall outside of the Cayman Private Fund registration regime (The Private Funds Law 2020). Our understanding is that if you have one investor, it will fall outside of the scope of the Private Fund registration regime, and even if you have even more than one investor, where the fund is closed-ended and provided that no offer is made, then you can also avoid Private Fund registration.

Another regulatory item to bear in mind if that, if you have decided that the creation of an entity is too complicated, then in a UK AIFM you should remember to check that you have the necessary permission under Article 6(4) AIFMD. Additionally, if your investor is in the U.S., you should consider whether this will trigger the need for full registration with the SEC. This continues to cause difficulties for UK managers, particularly those without a U.S. physical presence.

Terms

Fees

Other topics that come up when co-investments are being structured include what the terms of the arrangement should be, including: liquidity, holding periods, drawdowns, carried interest and fees. In terms of fees, it is particularly important to consider the applicability of Management Fees and the nature of the Performance Fees. For Performance Fees, consider what rate would be appropriate, whether or not there should be a hurdle and when that fee should crystallise. The answer to all of these points will depend on the nature of the co-investment but it is not uncommon for the performance fee to not be charged until the co-investment is liquidated at the end of the fund's lifecycle or after maybe three to five years.

Also on the subject of fees, we talked on a previous Hedge Fund Vista call (a note of which can be accessed here) about carry structures. Linked to fees, particularly in co-investment, sometimes the investment manager gets its investment fee / carry fee through a carry vehicle. The aim here is to get the performance fee in terms of an allocation that is taxed as capital gain, rather than being something that is taxed as income - therefore meaning that effectively you enjoy a lower rate of tax. In the carry concept, generally the investment is longer term and there are not usually the trading concerns for UK tax purposes.

When structuring a fund and looking to have it structured as a partnership, the above points address a number of the key fee related questions that need to be considered at the beginning in terms of structuring, as they link back to the choice of vehicle.

Liquidity

Liquidity is also a key consideration. Sometimes the investment managers are just considering the effort involved in structuring the co-investment and not liquidity. It is one thing for the investment managers to be given the appropriate window to structure the relevant asset during what they see as the investment lifecycle (to hopefully make some good returns on it), but also to consider, and perhaps more importantly, that the co-investment in the co-investment vehicle is more often than not, linked to the investment managers main fund and so any liquidation rights that the co-investment vehicle has could have a detrimental effect on the main fund. We often see investment managers looking to have no liquidity, which is often phrased as "no liquidity until the earlier of" a number of months or years, or a particular event happening. This also often includes a long stop, so that investors have some comfort that they won't be stuck in the arrangement for too long a period of time.

Obligation to follow on investments

This will depend on the nature of the assets, and how the vehicle will fund its operating expenses (such as the administrator, research etc). There are several ways of doing this (i) depending on the nature of the assets, it may be possible to liquidate to cover expenses; (ii) there may be borrowing arrangements in place, such as from the prime broker or another counterparty; or (iii) having a capital call mechanism, where investors can be called upon to cover situations where there are more expenses to pay for.

It is worth thinking about how the fund will pay for the research and making sure that the fund is getting this in a fair way with respect to the co-mingled fund which also invests in the same investment.

Information on opportunity

Typically, in the discussion phase of setting up a co-investment, the investment manager will typically want to provide information on why it believes this is a good investment. There are a couple of important points to consider here: (i) if you want to provide information to prospective investors, do you have the right to provide that information or are you subject to any restrictions, especially those which require consent; and (ii) the liability that attaches to certain information. It may be that you get information from the issuer of the relevant asset. When passing this information onto investors, the manager will want to ensure that they aren't effectively taking on liability for the accuracy of the information.

Conflict management

This is something managers must consider very carefully. The U.S. Securities and Exchange Commission published a risk alert in June 2020 relating to their observations on examinations of private fund advisers and common issues. The first item they raised was relating to conflicts of interest and disclosure. The requirements come out of the Advisers Act, and the obligations are pre-existing, but it was interesting to see the specific reference to co-investments. There were three examples of poor conflict of interest management and disclosure that were relevant to co-investments; (i) in terms of the allocation of investments between the flagship fund and the co-investment vehicle, there needs to be a clear policy of allocation; (ii) there needs to be better disclosure relating to the specific conflicts between the flagship fund and the co-investment vehicle; and (iii) expenses among the investment manager and its client, including the costs of aborted transaction, need to be fair. Complying with these should also ensure compliance with the FCA's policies on conflict management.

In summary, if you're thinking that a co-investment may be a possibility for your business, think in advance about disclosure in fund documents and all of the relevant policies. Put these into your fund documentation in the next routine update, in order to avoid having issues later down the line when there is a deal available and increased pressure on the business to act quickly.

Department of Labor - ESG / ERISA issues

The U.S Department of Labor has proposed a draft regulation to limit ESG considerations by ERISA.

Fiduciaries

Section 404(a)(1)(A) requires that ERISA fiduciaries act for the exclusive purpose of providing benefits to retirees and defraying plan expenses. This is a significant step backwards from the current position and is more in line with the 2008 guidance.

The draft regulation states that ERISA fiduciaries must never sacrifice investment returns or take on additional risks to promote collateral benefits.

The Department of Labor proposed amending the regulations under ERISA Section 404(A) because it is concerned that the growing emphasis on ESG investing may be prompting ERISA plan fiduciaries to make investment decisions for purposes distinct from their responsibility to provide benefits to participants and beneficiaries and defraying reasonable plan administration expenses.

Requirements in the Proposed Rule

Investment decisions must be based on their pecuniary factors (ie factors that present economic risks or opportunities to the plan's assets that qualified investment professionals would treat as material economic considerations under generally accepted investment theories).

Investments must be compared, on the basis of their pecuniary factors, to other available investments.

ESG factors can be used if the investments are "economically indistinguishable".

Key Takeaways

This regulation is merely proposed. Over 200 comments have been submitted and 13 Senators have commented that the proposal should not be adopted. There seems to be a substantial effort to push this through before any change in direction, however there are fairly powerful forces opposing the regulation which may well cause a delay due to the extent of their opposition.

This regulation has broad implications beyond ESG and would affect ERISA plan cash sweeps and investments in affiliated mutual funds.

This regulation needs to be watched, especially because if it were adopted as it is proposed, it would widen the division between the U.S. (ERISA) and European investment obligations regarding ESG.

Funds round up

There are a number of funds topics to be aware of more generally:

1. On the theme of ESG, please remember that 10 March 2021 is the deadline for a lot of the EU Sustainable Finance Disclosure Regulation obligations. We hosted a call on this recently, which can be accessed here.

2. If you are a UK manager and you have a fund with marketing notifications in the 27 EU jurisdictions, do keep an eye out for what you may need to do with these notifications so that they continue to stay in force after the end of the this year.

3. We are hearing that a lot of brokers are asking for increased due diligence on fund investors in terms of KYC requirements. Sometimes they are asking for more than what seems required from the relevant laws and regulations, both in terms of asking for information on fund investors when it may not be necessary to look at the fund at all (in the context of prime brokers for example), and also in terms of asking for a lower threshold than is required by law.

4. A final reminder that the deadline for registering s4(4) mutual funds with CIMA is 7 August 2020.