(Article from Registered Funds Alert, September 2020)
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In prior Alerts, we have critiqued certain aspects of the current form of co-investment exemptive orders that the SEC has granted to regulated funds seeking to invest alongside affiliated funds in negotiated transactions. We also have encouraged the SEC to approve a new form of co-investment relief, which has now languished with the Staff for over a year but would fix many of the issues that arise under existing co-investment orders. Recently, the SEC temporarily addressed one common criticism levied against existing co-investment orders by allowing an affiliate of a BDC to participate in a follow-on co-investment even if the affiliate had not previously participated in a co-investment with respect to the same issuer. In this Alert, we make the case for permanent implementation of this temporary relief and the extension of the relief to all regulated funds, as we believe it addresses a key investor protection problem inherent in the structure of existing co-investment exemptive orders and will enhance capital flow to the small businesses BDCs were designed to support.
Rationale for the Current Restriction on “New Funds” Participating in Follow-On Co-Investments Is Faulty and Inadvertently Creates Investor Protection Concerns
Historically, the co-investment relief granted by the SEC has been premised on the idea that a regulated fund and its affiliates should be similarly situated with respect to the investments they hold in an issuer. Illustrating this point, one of the key conditions of the relief prohibits a regulated fund from investing in reliance on the relief if certain affiliates have any pre-existing investment in the issuer. The purported policy rationale behind this condition is that it protects investors from a situation in which a regulated fund’s assets could be used to “prop up” an affiliate’s existing investment. Accordingly, this condition is often referred to colloquially as the “propping up” condition.
The SEC has allowed only two exceptions from the propping up condition. Under both exceptions, any participating regulated fund is required to already have an investment in the issuer, which should serve to mitigate the propping up concern. These two exemptions allow a regulated fund to participate in a follow-on co-investment in reliance on the relief with one key requirement—all affiliated funds that participate in the follow-on also have a pre-existing investment in the issuer (and, except in limited circumstances, all participants must hold the same securities of the issuer). However, by requiring all follow-on participants to have existing investments in an issuer, the SEC has failed to account for certain fundamental characteristics of private funds, inadvertently reintroducing propping up concerns that can harm investors in regulated funds.
The SEC seemingly has failed to account for the fact that private funds typically have a limited investment period. For example, a private fund may have an initial commitment period of one-to-two years, followed by a three-to-five year investment period and two-to-three year period of managing portfolio investments prior to selling those investments, winding down operations and distributing capital back to investors (and/or raising a successor fund). This limited lifecycle may prevent a private fund from providing capital in follow-on co-investments that occur after its investment period. Under current co-investment relief, if a private fund initially participated in a co-investment alongside a regulated fund and that investment later requires additional capital support, the regulated fund will need to provide that support on its own, and a sponsor cannot use capital from any affiliated private funds or proprietary accounts of the sponsor that do not have a pre-existing investment in the issuer (collectively, “new funds”). This can result in the regulated fund being required to prop up the private fund’s investment by funding more than its share of a follow-on investment. If the regulated fund and any other affiliates that are eligible to participate in the follow-on co-investment cannot provide sufficient capital, the investment could decline in value or the regulated fund could lose the investment altogether (for example, another sponsor provides the needed capital and refinances the issuer’s debt), which harms the Main Street investors who make up the bulk of capital in BDCs.
In the order temporarily permitting a BDC to participate in a follow-on co-investment with new funds, the SEC acknowledged that a BDC “may face challenges absent these exemptions in providing capital” to portfolio companies in light of COVID-19. The order does not acknowledge that this issue predated the pandemic and will continue to be an issue after the temporary relief expires. For the reasons outlined above, the temporary exemptive relief should be extended permanently, and be expanded to apply to all regulated funds that would seek to co-invest in a follow-on with new funds.
Many BDCs Have Successfully Utilized the Temporary Exemptive Relief, but it Still Has Its Limitations
A number of BDCs have relied on the temporary ability to participate in follow-on co-investments with new funds. This has allowed sponsors to support portfolio companies better during the pandemic, which has proven to be particularly challenging time for the type of portfolio companies BDCs are designed to support.
While the issuance of the temporary relief has helped support the BDC industry, it does not provide a complete solution to cash-strapped BDCs. In order for a new fund to participate in a follow-on co-investment under the temporary relief, a BDC is still required to participate in the follow-on transaction. Thus, while the temporary exemptive relief helps sponsors provide support to existing investments without forcing a BDC to overextend itself or sell other desirable investments at depressed prices to the same extent it may have absent the relief, the BDC still may face difficulty in funding even a small portion of a follow-on opportunity.
Adopting a New, More Principles-based Form of Co-Investment Relief Remains a Better Path Forward
In issuing the temporary exemptive relief, it is apparent that the SEC is not overly worried about private funds and a sponsor’s proprietary accounts being taken advantage of to prop up a BDC’s investments, presumably relying on the fact that investment advisers have an overarching fiduciary duty to those clients that should prevent such misconduct. This principle applies to regulated funds as well, and underpins the approach taken in the new form of co-investment relief that a FS Global Credit Opportunities Fund applied for last year (the “FS Application”).
Under the conditions of the FS Application, any follow-on co-investment that involved a new fund would require approval of a regulated fund’s board. The FS Application also fixes several other problems that arise under existing co-investment orders, including reducing the burden on regulated fund boards, reducing the administrative and compliance burden on sponsors to track and report to the board investment opportunities that fall outside a regulated fund’s strategy and would permit joint venture subsidiaries to participate in co-investments.
We continue to believe that the SEC should adopt co-investment relief in the form of the FS Application, and have been advocating for a more principles-based approach to co-investment relief for nearly two years. Absent broader reform to co-investment relief, a helpful first step would be to correct permanently the misguided restriction on new funds participating in follow-on investments.