Co-investment in private credit: structuring and fee considerations for sponsors

As private credit has matured, investor demand for co-investment opportunities has increased significantly and co-investment has become part of the product architecture rather than merely an ancillary relationship benefit¹. 

There is no single driver for this trend, but typically a combination of investors seeking: (1) enhanced returns, through access to individual credits on a reduced- or no-fee basis; (2) greater control over portfolio construction, through the ability to tilt exposure toward preferred sectors, geographies or risk profiles; and/or (3) stronger relationships with their sponsors and a better understanding of their origination, underwriting and monitoring processes. 

Co-investment has long been a staple of private equity, with the industry coalescing around a relatively standard structure that is well understood by sponsors and investors alike: co-investing investors invest in a sponsor-controlled SPV ((Special Purpose Vehicle) - typically a limited partnership) that then invests in a single underlying portfolio company alongside the flagship fund. 

The different dynamics typical in private credit – a larger number of investments and more compressed investment decision-making timeframes – result in both sponsors and investors looking for alternatives to the classic PE-style single asset co-investment SPV. Before selecting a structure, sponsors should be clear about what opportunity the co-investment programme is intended to solve for. In credit, the structuring choice is usually driven by five variables:

1. whether the investor requires lender-of-record status;
2. the degree of execution certainty required within compressed deal timelines;
3. the number and sophistication of co-investors;
4. the sponsor’s intended fee, carry and other economics; and
5. the regulatory, tax and operational footprint of the structure. 

The same investor demand may therefore point to very different legal architecture depending on whether the sponsor is seeking committed overage capital, a relationship-driven deal-by-deal allocation process, or a purely economic risk transfer. This article considers some of those alternatives from the sponsor’s perspective including their advantages and disadvantages. 

For the purposes of simplicity, we have not depicted in the diagrams below the detailed structure of a typical flagship fund, co-investment vehicle or SMA which often will comprise multiple vehicles (e.g. currency feeders and blockers). In addition, in the context of a typical private credit fund structure, it is very common for the fund/SMA vehicle to have a corporate asset holding company (an “asset holdco”) as a subsidiary of the fund through which investments are held. 

1. Direct co-investment

With this alternative, the co-investor effectively acts as a parallel lender of record under the same syndicated-form credit agreement as the sponsor’s flagship fund (and any other accounts – e.g. SMAs – managed by the sponsor). 

This is the least common of the structures we encounter; typically, because it puts the ongoing deal decision-making onus directly on the co-investor and beyond the sponsor’s control, which is unappealing for the sponsor and burdensome for the co-investor, and the difficulty the structure provides in structuring profit sharing between the sponsor and the co-investor.

 Direct co-investment advantages 

• Accesses certain pools of capital which require lender of record status. 

• Fewer house entities and, therefore, less cost and operational complexity of running them.

From a tax perspective, this option is relatively straightforward as there is no need for the sponsor to establish any bespoke vehicle for the purposes of the co-investment and consider the tax treatment and attributes of the vehicle. However, as mentioned above, it requires the investor to bring their own “exemption” (be it treaty or otherwise) where the underlying investment is in a jurisdiction which has interest withholding tax. In addition, the co-investors will be directly responsible for their own investment-related tax compliance aspects (e.g. completion of procedural formalities to access relief) which may not be desirable. 

2. Dedicated blind pool co-investment vehicles (sidecars)

Building off the favoured private equity model of establishing a single asset co-investment SPV at the time of the co-investment transaction, this option involves the sponsor forming a dedicated sidecar vehicle at substantially the same time as the flagship fund. Investors who commit to the flagship fund will have the option of committing to the sidecar, and capital committed to the sidecar will then be available to the sponsor to deploy in co-investment opportunities alongside the flagship fund, as and when they arise. 

The terms of sidecar vehicles can vary significantly – some give the sponsor full discretion to deploy committed sidecar capital; others give participating investors opt-in or opt-out rights – although typically sidecars will offer lower or no fees and carry. 

The key driver is to encourage greater investment in the flagship fund. Investors only get access to the co-investment vehicle if they have committed to the flagship fund. Some sponsors require investors to write a certain size cheque to the flagship fund to get access; others keep it entirely discretionary. 

We have seen limited examples whereby the sponsor has structured this through the flagship fund. However, unless it is a compartmentalised vehicle, those investors who are not participating may struggle to get comfortable with the potential cross-contamination of such co-investments with the flagship fund investments. 

From a tax perspective, the expectation would be that the sidecar structure mirrors the asset holdco structure of the flagship fund (e.g. if the flagship fund is a Luxembourg partnership with a Luxembourg company as the holding company, we would expect the co-investment vehicle to mirror that structure). However, there might be some flexibility on timing and the asset holdco under the co-investment vehicle could be set up prior to the first deal. Depending on the type of asset holdco used, there may be additional structuring considerations, for instance if the flagship fund uses a UK qualifying asset holding company as their asset holdco, whether the co-investment vehicle can use a similar asset holding company will depend on whether the conditions (including the ownership conditions) of the UK qualifying asset holding company regime are met.

3. SMAs

Some sponsors limit co-investment access to their SMAs – bespoke investment programmes agreed with significant investors. When an SMA’s investment parameters overlap with those of the sponsor’s flagship fund(s), the SMA and the fund(s) will invest alongside each other in accordance with the sponsor’s agreed investment allocation policy.

An SMA’s ability to access co-investment can either be given at the sponsor’s full discretion or with the SMA investor having an opt-in or opt-out right. It also may either be a dedicated SMA for co-investment only or an allocation to co-investment above and beyond their SMA commitment. 

From a tax perspective, the same considerations set out in section 2 above apply, albeit that the SMA would typically be an existing structure with its own asset holdco and as such should be generally able to invest alongside the flagship funds which aligns with the strategy it is pursuing.

4. Sub-participation

A contractual alternative, this involves the flagship fund being the (sole) lender of record with the underlying borrower and entering into a sub-participation agreement in respect of that position with the co-investor that transfers a portion of the fund’s economic risk to the co-investor without changing the underlying credit agreement. The fund remains the lender of record but economics and returns are passed to the co-investor before they hit the flagship fund vehicles.

This option is potentially the most involved from a tax perspective as the tax treatment of sub-participation can be complex depending on the structure and jurisdiction of the investment. The key points to consider would include the deductibility of the sub-participation payments for investors, withholding tax on sub-participation payments (usually not an issue) and whether the arrangements would impact the tax treatment of the underlying investment (e.g. whether the recipient of the interest is still considered to be the beneficial owner of that interest taking into account the sub-participation agreement). 

Structuring – a tailored approach

Ultimately, the optimal co-investment structure for a given sponsor and its investors will depend, to a significant extent, on tax considerations and the degree of control needed by investors. Other factors include deal size, borrower preferences and documentary references, the number of co-investors and – at both sponsor and investor level – internal resource and infrastructure. 

Finally, consideration needs to be given to the implication of AIFMD II on the proposed structure. For example, relevant questions are likely to include whether the arrangement constitutes a transfer, whether the 5% risk-retention requirement is engaged and whether the structure could be characterised as a loan-to-distribute strategy. AIFMD II is evolving as it is implemented and needs applying on a case-by-case basis.

Beyond the structuring – fee models

Historically, private equity co-investment was offered management fee and carry free. This was the initial basis on which investors sought co-investment opportunities in private credit. However, as management fee rates and carried interest percentages are lower in private credit, we have seen a divergence from the management fee and carry free model and sponsors thinking more creatively. For example:

• An upfront administration fee (akin to a one-time management fee). For certain investors who cannot pay management fees on their co-investment this can be a useful alternative structure.
• A ratcheted carried interest which is dependent on investment in other products of the sponsor. For example, full fees and carried interest are charged on the co-investment until the investor has invested a certain cheque size in other full fee-paying products.
• A ratcheted fee and carried interest based on number of, or quantum of capital deployed into, co-investments. For example, the first three co-investment opportunities are fee and carry free and then full fees and carry are paid on subsequent co-investments.
• The sponsor retains the co-investment’s pro rata share of other fee income (such as arrangement, monitoring, board, syndication or amendment fees) rather than applying that amount as an offset against the management fee, as would typically be the case for the flagship fund’s pro rata share.

It ultimately depends on the negotiation power of the investor and the underlying asset. As was seen recently² in private equity with the significant capital inflows from retail capital, sponsors may not need to continue offering reduced fees on co-investment to institutional capital as they can offer it on full fees to retail capital. The impact of retail on co-investment in credit though is yet to be seen.