Co-Investment, From the Side That Offers It
Co-investment is an allocation decision before it is an offer. Section 206 requires the conflict be disclosed for informed consent, and examiners found policies that went unfollowed.
By José Vasquéz, Managing Partner
9 min read · Growth Equity
In this note06 · 9 min
Co-investment is an allocation decision before it is an offer. When a general partner places part of a financing outside its main fund, Section 206 of the Investment Advisers Act requires that the conflict be eliminated or disclosed fully enough for informed consent. The SEC's examination staff found the recurring failure was rarely a missing policy. It was a written policy that went unfollowed, or a side arrangement left undisclosed.
01The Duty Behind the Allocation
Section 206 of the Investment Advisers Act of 1940 makes it unlawful for an adviser to employ any device, scheme or artifice to defraud a client, to engage in any transaction, practice or course of business that operates as a fraud or deceit upon any client or prospective client, or to engage in any act or practice that is fraudulent, deceptive or manipulative.
In a typical private fund structure, as the SEC has explained, the adviser's client is the private fund, and its investors are not clients. Rule 206(4)-8 closes that gap: it treats as fraudulent any untrue or misleading statement of a material fact, and any other fraudulent or deceptive practice, directed at any investor or prospective investor in the pooled investment vehicle. The allocation is owed to the fund, and every statement about the allocation is owed to every investor.
The Commission stated how that duty applies to allocation in its 2019 interpretation of the adviser's standard of conduct. When an adviser allocates investment opportunities among eligible clients and faces a conflict, it must eliminate or at least expose through full and fair disclosure the conflicts associated with its allocation policies, including how the adviser will allocate investment opportunities, such that a client can provide informed consent (Release No. IA-5248). The same release says an adviser need not allocate pro rata or follow any particular method. The law does not dictate the formula. It dictates that the formula be real, disclosed and followed.
Two further points in the release govern the drafting. First, disclosure that an adviser "may" have a particular conflict, without more, is not adequate when the conflict actually exists. A policy that says the manager may offer co-investment to certain investors, when it does so on most transactions, describes a present conflict in conditional language. Second, the Commission states that full and fair disclosure and informed consent cure the conflict itself, but do not by themselves satisfy the adviser's duty to act in the client's best interest. A disclosed allocation can still be a bad allocation.
02The Examination Record
On June 23, 2020, the SEC's Office of Compliance Inspections and Examinations published a Risk Alert on deficiencies observed in examinations of private fund advisers, and it described the allocation and co-investment conflicts it observed as inadequately disclosed and as apparent deficiencies under Section 206 or Rule 206(4)-8. Three findings bear directly on co-investment.
- Preferential allocation. Staff observed advisers that allocated limited investment opportunities to new clients, higher fee-paying clients, or proprietary accounts without adequate disclosure, and advisers that allocated securities at different prices or in apparently inequitable amounts, either without adequate disclosure or inconsistently with the process they had disclosed.
- Co-investment process. Staff observed advisers that disclosed a process for allocating co-investment opportunities among select investors, or among co-investment vehicles and flagship funds, and then failed to follow it. Staff also observed advisers that had agreements to provide co-investment opportunities to certain investors without adequate disclosure to the others.
- Shared expenses. Staff observed advisers that allocated shared expenses, including broken-deal and due diligence costs, among the adviser, its fund clients and co-investment vehicles in a manner inconsistent with disclosures to investors or with the adviser's own policies and procedures.
Each finding describes a gap between the written word and the act. That is why the Institutional Limited Partners Association asks that allocation policies be not excessively prescriptive, but sufficiently clear as to be verifiable ex post (ILPA Principles 3.0). For a registered adviser, the policy also sits inside the compliance program: Rule 206(4)-7 requires written policies and procedures reasonably designed to prevent violations of the Act, and a review, no less frequently than annually, of their adequacy and the effectiveness of their implementation. An allocation policy that no one tests against the deals actually done is a disclosure document, not a control.
03The Allocation Policy
The table below sets out market convention, drawn from ILPA Principles 3.0 and the examination record, as the elements of a written co-investment allocation policy. It contains no figure: sizes, limits and fee terms belong in each fund's governing documents. The column on what each element costs the general partner states LeverVenture's view of the burden on the manager. It is analysis, not a cited rule.
| Policy element | When offered | To whom, as a class | What it costs the GP | How conflicts are handled |
|---|---|---|---|---|
| Fund priority | Only after the main fund has taken what its strategy, concentration limits and remaining commitments allow | No one ahead of the fund | The option to place the most attractive transactions elsewhere | Every suitable opportunity goes first to the fund when it fits the strategy and the fund has remaining commitments (ILPA) |
| The excess tranche | When a financing is larger than the fund can prudently hold | Existing limited partners in the main fund, under the framework disclosed in the offering memorandum and partnership agreement; ILPA leaves the GP the option, not the obligation, to offer to electing limited partners or third parties | A written strategic rationale, on each transaction, for not allocating the whole amount to the fund | The framework, including any prioritization, is disclosed to all limited partners in advance (ILPA) |
| Side-letter rights | Granted when an investor commits, exercised as opportunities arise | Limited partners holding negotiated rights to evaluate or participate pro rata | Discretion surrendered in advance, and a disclosure obligation that runs to every other investor | The existence of the rights is disclosed to all limited partners; undisclosed arrangements were an examination finding (ILPA; OCIE) |
| Other vehicles of the GP | Only where the transaction exceeds the fund's capacity | Parallel or affiliated vehicles managed by the GP | An explanation to the advisory committee on each such allocation | Disclosure to the LPAC, with the reason the opportunity went beyond the fund, especially where the fund's concentration limit was not reached (ILPA) |
| GP and affiliate participation | Alongside the fund, never deal by deal | The GP, its principals and affiliates | No selective participation in individual transactions | Same securities and same terms as the fund, with related fees and expenses allocated pro rata across all classes of investors (ILPA) |
| Fees and offsets | Whenever a co-investment vehicle generates fee income | Investors in the main fund, as beneficiaries of the offset | Fee income that accrues to the fund rather than to the manager | Fees payable to the co-investment vehicle accrue to the underwriting fund and are offset against management fees; transaction-fee allocation between fund and co-investors is disclosed (ILPA) |
| Broken-deal and shared expenses | When a transaction fails or a shared cost is incurred | The fund and every co-investment vehicle that participated | Cost recovery from co-investors that may resist bearing it | Shared pro rata in most cases; limited partners are told of any co-investment vehicle that does not bear a pro rata share (ILPA; OCIE) |
| Follow-on investments | At each later closing of a company already held | The fund and the original co-investors, under the disclosed rule | A commitment, made at the first closing, about how later rounds divide | The allocation of follow-on investments related to co-investments is disclosed (ILPA) |
| Reporting and review | As each co-investment occurs, and at least annually | All limited partners | Records sufficient for an outside party to test the allocations | Co-investments reported as they occur, preferably with capital call notices (ILPA); policies reviewed at least annually (Rule 206(4)-7) |
From the side that offers it, co-investment is not a favor extended to investors. It is capital the fund could not or should not hold, placed under rules the manager wrote before the transaction existed, and tested afterward against what was done.
04The Economics of the Tranche
ILPA states that, unless the partnership agreement prohibits it, a general partner may charge management and other fees, such as transaction fees, on co-investments. Where it does, ILPA asks the manager to disclose how transaction and other fees collected from the portfolio company are divided between the fund and co-investors, and to align the approach to broken-deal expenses with the approach to co-investment fees. ILPA also suggests that advisory committees include limited partners without co-investment programs, as they are less likely to be conflicted. Where a co-investment is placed in its own vehicle, the structure is a special purpose vehicle, a separate entity that holds one position rather than a diversified portfolio.
The SEC observed in its 2023 private fund adviser release that advisers may offer co-investment vehicles with materially different fee and expense terms than the main fund, citing no fees or no obligation to bear broken-deal expenses as examples, and it stated that co-investment terms generally will be material given their impact on an investor's bargaining position (Release No. IA-6383).
That release adopted a rule restricting non-pro rata allocation of fees and expenses related to a portfolio investment held by multiple funds or clients, unless the allocation was fair and equitable and each investor received prior written notice. On June 5, 2024, the Fifth Circuit vacated those rules in National Association of Private Fund Managers v. SEC, No. 23-60471, and the SEC has confirmed that the newly adopted rules were vacated.
The vacatur removed a specific rule. It did not remove the conduct standard. Section 206, Rule 206(4)-8 and the 2019 interpretation remain, and the 2020 Risk Alert had already identified inconsistent allocation of broken-deal and due diligence expenses to co-investment vehicles as an apparent deficiency under those provisions. The broken-deal line is where the cost of co-investment to the manager is most visible. If co-investors bear none of a failed transaction's expenses, the fund bears all of them, and the investors who were not offered the tranche pay for the ones who were.
05Co-Investment in Life Sciences Financings
The clinical investigation of a previously untested drug is generally divided into three phases (21 CFR 312.21), and each phase can carry its own capital need. Where a biopharma or diagnostics financing is staged against clinical or regulatory milestones, the follow-on question arrives with the first closing rather than years later. A policy that discloses how the initial tranche is divided, and is silent on later closings, leaves the most consequential allocation to discretion exercised after the data are known.
LeverVenture's view is that a disciplined policy in mid-market life sciences should therefore address three points at the outset: how later tranches divide between the fund and the original co-investors, what happens to the allocation if a co-investor declines to fund a later closing, and how the fund's concentration limit is measured across closings. Each follows from ILPA's request that follow-on allocations be disclosed and from the Commission's requirement that conflicts be exposed before consent, not explained after the result.
06Frequently asked questions
Does a general partner have to offer co-investment pro rata to its limited partners?
No. In Release No. IA-5248 the SEC stated that an adviser need not have pro rata allocation policies or any particular method of allocation. The adviser must eliminate the allocation conflict or expose it through full and fair disclosure so that the client can give informed consent, and it must then follow the policy it disclosed.
What did SEC examiners find about co-investment in 2020?
The June 23, 2020 Risk Alert reported advisers that disclosed a process for allocating co-investment opportunities and failed to follow it, advisers with undisclosed agreements to give certain investors co-investment opportunities, and advisers that allocated broken-deal and other shared expenses to co-investment vehicles inconsistently with their disclosures.
Are the 2023 Private Fund Adviser rules on expense allocation still in force?
No. The Fifth Circuit vacated the rules on June 5, 2024 in National Association of Private Fund Managers v. SEC. Section 206 of the Advisers Act, Rule 206(4)-8 and the SEC's 2019 fiduciary interpretation were not vacated and continue to govern allocation of co-investment opportunities and expenses.
Nothing in this piece is investment, legal, tax or accounting advice, and nothing in it is an offer to sell or a solicitation of an offer to buy any security.
Former Chairman of JumpStart Inc. He has founded, scaled and exited companies across media, nutrition, real estate and human-resources technology, and owned the revenue line in every one of them. What he brings to a position is that operating experience at scale, investment acumen, an advanced diligence capability, and technology and artificial-intelligence expertise. He invests the way he operated: inside the business, on the plan, alongside the management team.