Co-investment economics differ from the fund's, and the document says how.

A fund finds a position larger than its concentration limit allows it to take whole. It takes what it may and offers the remainder to investors beside the fund, in a vehicle formed for the position, and those investors hold the position on terms the fund's constitution does not reach. The co-investment has its own document, its own economics and its own exit, and each is set by what the co-investment document says rather than by the fund's waterfall, because the fund's waterfall governs the fund's units and the co-investment vehicle has none. Managers that treat the co-investment as an extension of the fund find, at the position's sale, that the co-investors' economics, the fund's economics and the manager's are three different things, and that the document which should have said how they differ said nothing.

This note sets out what a co-investment is and why it exists, the allocation as the first economic term, the vehicle, the charge and carry on the co-investment, the exit and its alignment with the fund's, the information and governance the co-investors hold, the conflicts the arrangement creates, the lender's reading, the onshore interface, a comparison, a worked co-investment as a type, cases, what each party holds, the sequence, questions, terms and what to read.

What a co-investment is

A co-investment is a direct holding, by investors beside the fund, in a position the fund also holds, made at the same time, on the same entry terms, through a vehicle formed for it. It differs from a parallel fund, which invests in everything the fund invests in; from a feeder, which holds units in the fund; and from a secondary, which buys a holder's units. It exists because the fund's constitution limits concentration, because a position is larger than the fund can take, or because an investor wants more of one position than its fund share gives it. The co-investors are usually holders in the fund, sometimes third parties, and the co-investment right in a holder's side letter is the term that gives it the offer.

The allocation

The first economic term is the allocation: how much of the position the fund takes and how much is offered beside it, and to whom. The fund's constitution fixes the fund's share by its concentration limit and by the manager's duty to the fund; the manager may not allocate to co-investors a share the fund could and should have taken. The allocation policy, adopted by the manager and disclosed to the register, says how the co-investment share is offered: pro rata to holders with the right, by priority to the anchor, by the manager's discretion within stated criteria. A policy that is not written is a discretion, and a discretion exercised in favour of a holder the manager is raising its next fund from is a conflict the committee reads.

Why the fund's waterfall does not reach it

The fund's waterfall runs on the fund's cash flows to the fund's holders in the order the constitution fixes. The co-investment vehicle is a separate person with separate holders, and its cash flows go to them under its own document. Nothing in the fund's constitution binds the co-investment vehicle, and nothing in the co-investment document is governed by the fund's constitution unless the co-investment document says so. A manager that expects the fund's hurdle, catch-up and carry to apply to the co-investment has expected a document to reach a vehicle it does not name, and the administrator, running the co-investment's accounts, will run whatever the co-investment document says, including nothing.

The separation is the point. The co-investors took a position the fund could not take whole, on terms they negotiated for that position. If the fund's economics reached them they would have subscribed for more units instead. The co-investment document says how its economics differ because the difference is why the co-investment exists.

The right in the letter

The co-investment right in a holder's side letter is a right to be offered, within the allocation policy, a share of co-investment the fund makes available. It is drafted with care because it is an economic term that a most-favoured-nation clause in another holder's letter may reach, and the exclusions are drafted to keep a priority right tied to the anchor's status. The right says whether the holder is offered pro rata with others or first, within what period it must respond, on what terms the co-investment will be made, and whether the right survives a transfer of the holder's units. A right without a response period is a right that delays the position; a right without terms is a negotiation at each offer.

The offer and the response

The manager offers the co-investment by notice under the policy: the position, the amount available, the terms of the co-investment document, the response period, and the consequences of a partial take-up. Holders respond within the period, and oversubscription is scaled under the policy, undersubscription is re-offered or filled by the manager from third parties under the policy's terms. The offer notice and the responses are the record the committee reads when a holder asks why it received what it received, and a manager that offered by telephone has no record.

The vehicle

The co-investment vehicle is formed for the position: a company or partnership in a register jurisdiction, holding the position beside the fund, with the co-investors as its holders and the manager or an affiliate as its manager. Its document is its own constitution and a shareholders' or partners' agreement, and it carries the economics, the governance, the exit and the information terms. A vehicle formed from a template for the fund's own document carries the fund's terms by accident, including a waterfall that has no fund to run on; the co-investment document is drafted for the co-investment.

The charge and the carry

The fund charges the manager's annual charge on commitments or invested capital and carries the manager's share of gains above a hurdle. The co-investment's charge and carry are the co-investment document's, and the usual position is lower than the fund's: a reduced annual charge, or none, and a reduced carry, or none, because the co-investors took a position the manager had already found and diligenced for the fund. The level is a negotiation, and the anchor's letter may fix it. A co-investment with no charge and no carry is a co-investment the manager runs for the relationship; one with the fund's full economics is one the co-investors will not take twice.

The charge's base matters too. A charge on the co-investment's invested capital is a charge on the position's cost; a charge on commitments, for a vehicle that draws once, is the same number. The carry's hurdle runs on the co-investment's own cash flows, from the co-investors' contribution date, and the co-investment's carry is a deal-by-deal carry by construction, because the vehicle holds one position. The clawback question the fund's whole-fund waterfall answers does not arise, and the co-investment's carry is paid at the position's sale and not before.

The co-investment's own hurdle

The co-investment's carry runs above a hurdle on the co-investment's own contributions from their date. The hurdle's rate is the co-investment document's, and a document that borrows the fund's rate borrows a number chosen for a diversified portfolio with a drawdown profile and applies it to a single position funded once. The rate may be the same; the reason for it is different, and the document states it. The catch-up, if any, and the carry rate are likewise the co-investment's own, and the administrator runs one waterfall on one set of cash flows from one date, with no other position to net against and no clawback to hold, because the position's sale is the vehicle's end.

The co-investment's term and dissolution

A co-investment vehicle holding one position ends when the position is sold, and the document says so: dissolution on the sale, distribution of the proceeds under the waterfall, and a reserve for the vehicle's final liabilities. A vehicle that holds after the sale, because the document did not provide for its end, is a vehicle with costs and no purpose, and the co-investors pay its administrator and its registered office until someone winds it up. The document's term is the position's life.

The fund's holders who did not co-invest

Holders without the right, or who declined the offer, hold the position through the fund only, and the co-investment's existence affects them in three ways. The fund's share is smaller than the position, so the fund's concentration in it is what the limit allows and no more. The co-investors have information and governance the fund's holders receive through the fund's reporting only. And the manager's economics on the position are the fund's and the co-investment's together, which the register is told because the manager's incentive on the position is the sum. A fund that reports the co-investment's existence, its holders and its terms in the next report has told the register what it holds beside.

The exit

The fund and the co-investors hold the same position and may want to exit at different times. The co-investment document aligns them: a drag by the fund, so that the fund's sale takes the co-investors with it at the same price; a tag for the co-investors, so that a fund sale includes them; and a restriction on the co-investors' separate sale, so that the fund's control of the position is not disturbed. Without these, the fund sells its share to a buyer that inherits the co-investors as minorities, at a price that reflects it, and the co-investors hold a minority in a company they did not choose.

Alignment is not identity. The fund has a term and must sell by its end; the co-investors may have no term and may prefer to hold. The document says whether the drag runs at any time or only within the fund's term, and whether the co-investors may buy the fund's share at the fund's exit instead of being dragged.

Information and governance

The co-investors hold a direct position and expect the information a direct holder has: the position's accounts, the valuation, the board's decisions. The co-investment document fixes what they receive and when, and their governance: a board seat, a consent over reserved matters, or neither. A co-investment whose holders have less information than the fund's holders receive about the same position is a co-investment whose holders ask why, and one whose holders have more is a co-investment whose information flows into the fund's register through the holders who sit in both.

The conflicts

The arrangement creates conflicts the committee reads. The manager allocates between the fund and the co-investors and has an interest in each. The manager sets the co-investment's charge and carry and the fund's, and an anchor with a co-investment right is a related party on the allocation. The manager may exit the fund's share and the co-investors' share at different times and has a carry on each that runs differently. Each conflict is named in the allocation policy and the co-investment document, approved by the committee where the constitution requires it, and reported to the register.

The lender's reading

A capital-call lender to the fund reads the co-investment for what it does to the fund's position: whether the fund's share is the controlling share, whether the drag gives the fund a clean exit, and whether the co-investment vehicle has debt that ranks ahead of the fund's equity in the position. A lender to the co-investment vehicle, if it has one, reads the co-investors' commitments and the vehicle's single position. The two lenders do not share a base.

The onshore interface

A position in a register jurisdiction is held onshore by a company in which the fund and the co-investment vehicle are both shareholders, or by a company in which a holding company is the sole shareholder and the fund and the co-investment vehicle hold the holding company. The first puts the co-investors on the onshore register with the transfer cost and the foreign ownership rules that entails; the second keeps the onshore register to one name and puts the alignment terms in the holding company's document. The choice is the chain's, and the co-investment document is drafted to the chain.

By term · by instrument	In the fund	In the co-investment	Who sets it
Allocation	Concentration limit, manager's duty	Allocation policy, the right in the letter	The constitution and the policy
Annual charge	On commitments, then invested capital	Reduced or none, on invested capital	The co-investment document
Carry	Whole-fund or deal-by-deal, with hurdle	Deal-by-deal by construction, reduced or none	The co-investment document
Exit	The fund's term and the manager's discretion	Drag, tag, restriction, aligned to the fund	The co-investment document
Information	The fund's reporting	The position's reporting, direct	The co-investment document
Governance	Committee on conflicts	Board seat or consent, or neither	The co-investment document
Conflicts	Committee approval, disclosure	Named in the policy and the document	The allocation policy

The onshore registers and two holders

Where the position is held onshore by a company with the fund and the co-investment vehicle as the two shareholders, the onshore register carries both and the onshore regime's rules on foreign ownership, transfer approval and pre-emption apply to each. A co-investment vehicle that is foreign in the onshore regime's terms counts toward the foreign ownership limit beside the fund, and a chain designed for one foreign holder may not have room for two. The holding company alternative keeps one name on the onshore register and moves the two-holder question to a jurisdiction whose register does not ask it, and the alignment terms sit in the holding company's document where the onshore regime does not read them.

A co-investment, as a type

A fund finds a position at twice its concentration limit. The allocation policy provides that the fund takes its limit and the remainder is offered pro rata to holders with the right, the anchor first. The manager forms a co-investment company in the fund's register jurisdiction, with a document drafted for it: a reduced annual charge on invested capital, a reduced carry on the position's own cash flows above the fund's hurdle, a drag within the fund's term, a tag, a restriction on separate sale, the position's reporting to the co-investors, and a consent over the sale price. The position is held onshore by a holding company in which the fund and the co-investment company are the two shareholders, with the alignment terms in the holding company's document. The committee approves the allocation as a related-party matter because the anchor has the priority, and the allocation is reported to the register. At the sale, the fund drags, the co-investors receive the same price, the co-investment's carry runs on its own cash flows, and the fund's runs on the fund's.

The structure paper's page

The structure paper carries a page on co-investment: the policy's form, the rights in the letters and their exclusions, the vehicle's document and the terms it must carry, the onshore chain for two holders, the valuation by one valuer, the conflicts and their approval, and the exit alignment. The page is written at the fund's design, before the first position, because a co-investment found after the first close is structured under a policy that already exists or under none.

Third-party co-investors

A co-investment offered to third parties, because the holders' take-up was short, brings into the position holders who are not in the fund's register and have no relationship with the manager beyond the co-investment document. Their terms are the co-investment document's only, their information is what it gives them, and their presence on the co-investment's register is a disclosure to the fund's register under the policy. The manager's conflict in offering to a third party it hopes to raise from is the same conflict as with a holder, and the policy names it.

The second fund's reading

A manager's co-investment record is read by the next fund's prospective holders: how often co-investment was offered, to whom, on what economics, and whether the exits aligned. A record of co-investment offered under a policy, on a document drafted for it, with one valuer and a drag that ran, is a record a prospective anchor reads as competence; a record of discretionary offers to the holders the manager was raising from is read as the opposite. The policy written at the first fund's close is the second fund's evidence.

Four cases, as types

A manager offers co-investment to one holder by discretion, without a policy, and the holder is the one whose second-fund commitment the manager is seeking. The other holders with the right read the side letters at the first report and ask why they were not offered.

A co-investment vehicle is formed from the fund's template and carries the fund's whole-fund waterfall. At the position's sale the administrator finds a waterfall with one position and no other fund to net against, and the carry is computed on a document that did not contemplate it.

A co-investment has no drag and the fund's term ends. The fund sells its share to a buyer that will not take a minority beside co-investors who will not sell, at a discount the fund's holders bear.

A co-investment has a policy, its own document, aligned exits and reported conflicts. The position's sale runs at one price through one drag, and the economics of each side are what each document said.

What each party holds

The manager holds the allocation policy, the co-investment document and the conflicts it names.

Counsel holds the co-investment document, the alignment terms and the onshore chain's documents.

The committee holds the related-party approval of the allocation and its reporting.

The co-investors hold the right in their letters, the co-investment document's terms, their information and their governance.

The administrator holds the co-investment's own accounts, charge and carry.

The lender holds its reading of the fund's share and the drag.

Where it surfaces

It surfaces at the first co-investment offer, when holders with the right read the policy for the first time and find it was never written. It surfaces at the co-investment vehicle's formation, when counsel is handed the fund's template. It surfaces at the position's first valuation, when the fund's mark and the co-investment's mark differ because two valuers were appointed. It surfaces at the exit, when the buyer asks who else holds the position and on what terms, and whether a drag exists. It surfaces at the administrator, when the co-investment's carry is computed on a waterfall drafted for another vehicle. And it surfaces at the committee, when a holder asks whether the anchor's priority was an allocation the manager made to win its next fund.

The cost of getting it wrong

An allocation without a policy costs the manager the register's confidence in every allocation after it. A co-investment document from the fund's template costs a carry dispute at the exit. A missing drag costs the fund's holders the discount a buyer takes for minorities it cannot remove. Two valuers cost a mark that differs between vehicles holding the same thing, and the difference is a question at both registers. And a conflict not named costs what the regime charges for a conflict found by inspection rather than disclosed by the manager.

The manager's economics across the two

The manager earns the fund's charge and carry on the fund's share and the co-investment's charge and carry on the co-investment's share, and the total is what the manager earns on the position. A manager that allocates more to the co-investment than the policy allows, because the co-investment's economics are better for it, has allocated against the fund; one that allocates more to the fund than the fund should take, because the fund's economics are better for it, has breached the concentration limit. The allocation policy fixes the split by the fund's constitution and the manager's duty, and the manager's economics follow from the split rather than the split from the economics.

A timeline, as a type

At the fund's first close the allocation policy is adopted and the anchor's letter carries a priority co-investment right, excluded from the reach as tied to status. In year two a position at twice the limit is found; the manager offers the remainder by notice under the policy, the anchor takes its priority share, three holders take pro rata, and the offer record is filed. The co-investment company is formed on its own document with a reduced charge and carry, a drag within the fund's term, a tag, a restriction and a consent over the sale price. The onshore holding company's document carries the alignment terms. The committee approves the anchor's priority as a related-party allocation and the register is told. One valuer marks the position for both vehicles. In year six the fund sells under the drag at one price; the co-investment's carry runs on its own cash flows above its own hurdle; the fund's runs on the fund's; and the administrator's two sets of accounts close the position.

The sequence

1. The allocation policy is adopted and disclosed at the fund's first close, and the co-investment right is drafted in the letters within the exclusion set.
2. A position exceeds the fund's limit; the fund takes its share under the constitution and the remainder is offered under the policy.
3. The co-investment vehicle is formed with its own document: charge, carry, drag, tag, restriction, information, governance.
4. The onshore chain is designed for two holders or for one holding company, and the alignment terms are placed accordingly.
5. The committee approves the allocation where a related party benefits, and the allocation is reported.
6. At the exit the drag runs, the prices match, and each document's economics run on their own cash flows.

Questions a manager asks

Should the co-investment carry no charge. A co-investment without charge or carry is a concession to the relationship; most carry a reduced charge and a reduced carry, and the anchor's letter fixes them.

Can the fund's carry be netted against the co-investment's. No; they are different vehicles with different holders, and netting would transfer economics between them.

Who may co-invest. Holders with the right, by the policy; third parties only if the policy allows and the register is told.

What if the fund wants to sell and the co-investors do not. The drag, within its terms; a co-investment document without a drag is a document that lets the co-investors set the fund's exit.

Does the co-investment count toward the fund's concentration limit. The fund's share does; the co-investment's share is outside the fund and outside the limit, which is the point.

How is the co-investment valued. By the fund's valuation policy applied to the position, so that the two vehicles carry one mark.

Terms used

Co-investment: a direct holding beside the fund in a position the fund also holds.

Allocation policy: the manager's written rule on how co-investment is offered.

Drag and tag: the fund's right to take the co-investors into its sale, and the co-investors' right to be included.

Deal-by-deal carry: carry computed on one position's cash flows, as the co-investment's is by construction.

Holding company: the onshore or intermediate company in which the fund and the co-investment vehicle hold the position together.

Related-party allocation: an allocation in which a holder with influence over the manager benefits, approved by the committee.

What to read

The allocation policy; the co-investment vehicle's constitution and shareholders' agreement; the anchor's letter on co-investment; the holding company's document; the facility's treatment of the fund's share. On this site, the worked co-investment structure and the economics and vehicles rooms under Structures.