Private equity firms facing Securities and Exchange Commission (SEC) examination in recent years have been preparing for scrutiny of several aspects of their investment adviser compliance programs. One area of enhanced focus in SEC exams that warrants attention is external co-investments, which are investments in portfolio companies by fund limited partners (or other outside parties) alongside one or more private equity funds.
Much of the recent growth in private equity fundraising since the financial crisis has come from separate accounts and co-investments instead of traditional fund investments. Limited partners of all sizes are increasingly seeking co-investment opportunities when negotiating new fund agreements with advisers. They are attracted by greater deal selectivity and the prospect of higher new returns through lower fees.
The SEC examination staff has been assessing co-investment practices as part of its broader expressed concern about conflicts of interest in private equity. We believe examiners may focus on preferential allocation of lucrative co-investment opportunities to some limited partners and not to others, and possibly at the expense of primary funds. Examiners may also question whether primary funds are bearing more than their fair share of broken deal expenses when significant co-investor participation is contemplated to pursue larger deals.
This A closer look (a) provides an overview of recent trends in private equity co-investment, (b) describes the SEC staff’s areas of potential concern and exam focus, and (c) offers leading industry practices for mitigating compliance risks.