Commentary: The rise of co-investment SPVs for institutional investors

One of the most popular investment structures in today's alternative investment universe is the co-investment special purpose vehicle. SPVs traditionally are formed for the limited purpose of making one investment to be held for a finite time period. Institutional investors, such as pension funds, endowments, foundations and sovereign wealth funds, are increasingly clamoring for SPVs because they are typically among a manager's "best ideas."

Moreover, SPV offering documents disclose the actual investment name or a detailed description of it, unlike private equity funds or hedge funds. This allows institutional investors to better control their portfolio exposures. There are, however, some important issues to be considered when getting involved with an SPV investment.

Many institutional investors prefer investing through an offshore corporate structure, primarily for various tax reasons, including unrelated business taxable income, effectively connected income and reporting concerns. Oftentimes, however, given the short time runways associated with funding these SPVs, the manager might determine that a more complicated offshore fund launch is not desirable, and will seek to establish solely a U.S. fund to accommodate all investors. As such, institutional investors will need to consult with a tax adviser to understand the ramifications of such an investment, as there are often instances where the tax consequences will be minimal and might be far outweighed by the potential investment return.

SPVs, like hedge funds and private equity funds, may assess some sort of management fee, a carried interest or performance allocation, and various expenses. If the SPV is an overflow vehicle off of the manager's flagship fund, the management fee should reflect whether any extra work is being done by the manager — if little new work is being done, this should result in a low SPV management fee.

With respect to the carry, while a manager's hedge fund could charge an annual performance allocation, the same asset held in an SPV may instead be subject to a private equity-like distribution waterfall, since it is often the sole asset in the SPV portfolio. Lastly, with respect to expenses, investors will need to ensure that there is an equitable allocation policy in place to split in a fair manner any costs that are being shared among the manager's multiple products.

Another situation that should require close due diligence is how will the manager allocate investment opportunities that may be appropriate for more than one of its products. The manager should adopt a robust compliance policy, which addresses issues such as weighting determinations, the treatment of insider money, conflicting buy/sell decisions and related fiduciary duties, and the relative fees charged in each product.

As many of the positions held in SPVs will tend to be illiquid, the manager will need to determine fair value in accordance with valuation procedures that might require the use of third-party valuation agents and/or multiple secondary market quotes. In such a case, particular due diligence focus should be on what the pricing policy is, does it reflect best practices for the underlying asset, and whether and how the manager may override outside pricing.

From a cash management standpoint, institutional investors should note that, unlike in hedge funds, generally investors will not be permitted to voluntarily withdraw from an SPV. However, the manager will typically reserve the right to affect a mandatory redemption of an investor (with or without cause). Usually the only exit will be via distributions upon a realization event. So investors who have a need for liquidity might be averse to this type of offering.

Many SPVs have drawdown mechanisms tied to capital commitments (similar to private equity funds), while others require that all capital be contributed on day one. The former creates some administrative challenges for the manager, especially when the investment needs to be made quickly. Either way, investors will be under significant pressure to come up with cash promptly when asked, or face default penalties.

In sum, while SPVs are a flexible investment vehicle with many unique benefits, one should review the foregoing issues carefully before proceeding with an investment in such a structure.

Steven Nadel is a partner at Seward & Kissel LLP, New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.