Here Are the Pitfalls When Allocators Make Direct Deals or Co-Investments

Legal experts weigh in on contracts, due diligence, and potential conflicts when pension funds and other investors do deals outside a fund structure.

Illustration by II

Illustration by II

In search of yield, asset owners are increasingly turning to co-investments — where they invest in companies alongside private equity firms or hedge funds — and direct deals in the hopes of higher returns. But experts warn investors that these complex transactions pose their own challenges.

These deals not only benefit asset owners, but also investment managers, according to Jennifer Post, a partner at law firm Thompson Coburn. They can attract institutional capital into their funds by offering a chance to invest directly. “This allows them to leverage their capital base so they can lead bigger deals, gain market share, and can build a track record of increasing assets under management,” said Post.

Although these investments du jour promise big returns, investors must be careful to make sure they have enough capacity to handle their unique structure, according to legal experts.

“With these arrangements come complexities, challenges, and regulatory issues that need to be carefully evaluated,” added Post.

Hartford HealthCare and Arizona’s Public Safety Personnel Retirement System are two recent examples of institutions incorporating co-investment strategies into their portfolios, while the California State Teachers’ Retirement System signaled last year that it would shift its focus to direct deals, much like Canadian pension plans have long done.


An investment team’s challenge begins when sourcing deals. Edward Tran, a partner at Katten Muchin Rosenman, said that he recommends hiring an in-house team to find and conduct the due diligence necessary on these deals.

“Institutional investors will need to have the capacity to properly conduct commercial and legal due diligence,” Tran said, adding that this often requires allocators to add staffers with new and different skill sets and experiences.

He noted that this is less crucial for co-investment deals as the asset managers offering the opportunity can complete some of the due diligence work necessary for decision-making.

When co-investing, allocators should consider the proportion of their capital they’d like to commit to the main fund as opposed to their side commitments, Post said. “There shouldn’t be a deviation in how the investment is managed on the fund and co-investment side,” she added. “We want to make sure that’s addressed in the documentation.”

She added that investors need to lay out their liquidity needs and risk tolerance ahead of time to ensure that they are aligned with their managers and other allocators in the group.

“Conflicts can arise when [some in] the co-invest group [have] a need for liquidity sooner or [have] a lower tolerance for risk,” Post said. “They may bring some pressure on the manager or seek a less risky strategy in the investment.”

When they structure either co-investment or direct deals, institutions can ask for customized or enhanced reporting from their managers. Co-investors can also set the terms of any follow-on commitments in their initial deal agreements, Post said.

One potential pitfall? Post said that some investors want a guaranteed first look at all transactions in the main fund. But that may not be realistic, given the needs of that main fund’s other investors.

When it comes to direct deals, while some of the same guidance applies, there are other considerations institutions should make.

According to a report published by Katten Muchin Rosenman in late July, investors should consider asking for pre-emptive rights, which ensure that they can maintain the size of their stake, even if the company seeks further funding. They can also ask for anti-dilution rights, which allow allocators to adjust the value of their shares in the target business should the company sell them at a lower price at which they were acquired.

Investors can write control rights into their contract, which give them the ability to add board members and veto certain business decisions, and should put in place provisions for deadlock resolution, which addresses differences in opinion between a company’s many investors.

According to Post, when there are appropriate legal protections in place, direct and co-investment blow-ups are rare.

“I have not seen disastrous situations,” she said. “If things are documented well enough up front, there shouldn’t be any issues.”