Minority Approval Rights
The right of a co-investor to approve certain actions or veto board decisions of the SPV or Portco isheavily negotiated in co-investment transactions. As the PE Fund often takes operational control of the Portco, co-investors will look to have the right to approve a pre-negotiated list of matters that they deem critical to protecting their investment.
When determining which matters should be subject to minority approval rights, the parties should consider the effect that such approval rights might have on the Portco’s ability to make decisions quickly and efficiently. Some of the more common minority approval rights that are sought by co-investors include the right to approve:
(a) any amendments to the Portco’s organizational documents;
(b) the entering into of any material transactions outside the ordinary course of business (e.g., taking on any debt over a predetermined threshold, entering into a related-party transaction, amending the compensation of management of the Portco outside of ordinary course, or entering into a strategic relationship in which the contribution is greater than a predetermined threshold);
(c) the entering into of any fundamental transactions outside the ordinary course of business (e.g., amalgamation, merger, reorganization, or sale of all or substantially all of the Portco’s assets);
(d) the authorization, creation, or issuance of any class of securities of the Portco that impacts or has preference over any class of securities held by co-investors; and
(e) the declaration or payment of any distribution, whether in the form of a dividend or return of capital.
Whether a particular co-investor receives some or all of these approval rights depends on the nature of the co-investment, the role of the co-investor, and the bargaining power of the co-investor.
In order to monitor their investment, meet their reporting and disclosure requirements, and hold management accountable, co-investors should look to negotiate rights to access and receive ongoing detailed information regarding the Portco. While certain corporate statues mandate that shareholders receive audited annual financial statements (unless the corporation is not a reporting issuer and the shareholders unanimously waive the audit requirement on an annual basis), shareholders’ agreements will often provide shareholders the right to receive management-prepared monthly and quarterly interim financial statements, as well as management-prepared budgets and financial forecasts. In addition, co-investors should look to receive notice of certain events, such as notice of the commencement of litigation against the Portco. Co-investors must also consider their own internal reporting obligations and ensure that they can meet these obligations with respect to the Portco based on the rights they negotiate. As is the case with other minority protections, the scope of a co-investor’s contractual information rights will depend on the size of the co-investor’s investment and the type of co-investment transaction.
Co-investors should look to ensure that they have the right to maintain their ownership percentage in the Portco and/or Holding Company by negotiating robust preemptive rights on any future issuance of shares by the investment vehicle. Notably, there are certain equity issuances that are regularly carved out of the preemptive rights regime, including issuances that are part of the Portco’s equity incentive plan and issuances in connection with a transaction that has received shareholder approval.
Fees and Related-Party Transactions
Investors who invest through a PE Fund will typically be charged management fees that are calculated as a percentage of the total committed capital. PE Funds will also charge incentive fees that equate to a percentage of the profits earned on investments by the PE Fund, with such incentive fees becoming payable by investors only after a certain return threshold has been achieved. When an investor makes a co-investment outside of the PE Fund, the manner in which fees are charged differs from that when investing through the PE fund. Where management and incentive fees are directly charged on co-investments, they are usually capped and lower than when investing directly into the PE Fund. Whether such fees are charged will depend on the needs of the PE Fund sponsor, as well as the form of the co-investment structure, including whether the co-investor is an active or passive co-investor. Co-investors should also consider what fees and expenses they will be required to cover relating to the investment, operation, and sale of the investment vehicle. These fees are heavily negotiated and will impact the potential return on investment of each party.
Although the use of co-investment structures can lead to reduced or no management and incentive fees, co-investors may still bear indirect fees, as the PE Fund and/or its affiliate or another third party will typically charge management fees or other fees and expenses to the Portco and/or Holding Company. These fees and expenses are in consideration of the PE Fund managing the investment vehicle or providing other services, such as deal support. Consequently, co-investors should consider seeking contractual protections to prevent the PE Fund sponsor from increasing or introducing additional fee-bearing arrangements beyond what is disclosed and agreed to by the parties as of the closing of the initial investment. Such contractual protections may take the form of an approval right by the majority of co-investors or a covenant by the PE Fund sponsor to disclose to co-investors all fee-bearing arrangements between the Portco and/or Holding Company and the PE Fund sponsor (or any of its affiliates). An alternative approach would be to require that all such arrangements be entered into on arm’s-length terms, though it may prove difficult to demonstrate that a particular fee-bearing arrangement between the Portco and/or Holding Company and the PE Fund sponsor does not reflect arm’s-length terms. Any restrictions on fees should be reasonable to reflect the services to be provided by the PE Fund sponsor.
Co-investments will continue to play a significant role in private equity due to the advantages outlined in this article. It is critical that both co-investors and PE Funds carefully consider the various ways in which co-investments can be structured in order to ensure that all parties are aligned and working towards a common goal of creating value for investors. The parties should look to strike a balance between the need for co-investors to protect their investment and the need to provide the PE Fund sponsor with the latitude to make operational decisions based on its expertise so that it may maximize returns.