As deal sizes have grown and valuations have escalated, so-called club deals involving consortia of financial (and, sometimes, a combination of financial and strategic) investors have proliferated. This phenomenon and its complexities have been widely reported, and commentators have provided sound advice as to how to avoid the pitfalls of club deals to make them work more efficiently. In this context, the trade press has also reported on the increasing frequency with which private equity firms rely upon co-investors to complete large transactions, and the challenges of involving co-investors directly in the deal-making process. Less frequently discussed, however, is the growing use of so-called side car or over-allocation funds to meet the need for additional equity capital to complete larger acquisitions. Yet there are advantages and disadvantages to using these vehicles and structural considerations that require attention to use side cars most effectively.

What is a side car?

A side car or over-allocation fund is a blind-pool co-investment vehicle under common sponsorship with a private equity fund. The side car fund has a right of second opportunity to participate in larger investment opportunities brought by the fund sponsor to the lead private equity fund. Because side car funds are under common sponsorship with the general partner's (GP's) lead fund, their use can help avoid many of the complexities created by club deals. That is to say, the difficulties created by multiple equal parties in negotiations that can be associated with club deals can be avoided because deal management is co-ordinated under the auspices of one sponsor. So long as the terms of the side car fund are structured properly (as will be discussed below), the interests of the co-investing funds maintain proper alignment. Investment track record attribution is not an issue in connection with the use of side car funds, because it is clear where lead responsibility resides. Because side car funds are, as we define them here, blind pool, they avoid the most frequently-sited problems attributable to co-investments: the time and uncertainty of closure involved in providing these opportunities directly to limited partners (LPs) who must independently underwrite them. In sum, side car funds provide the coordinated management and instant access to committed capital to which GPs are traditionally accustomed.

Blind-pool side car vehicles are not without disadvantages, however. Some LPs hunger for co-investment opportunities because they want the transparency provided by independently underwritten co-investments as they are traditionally structured. Indeed, an increasing number of LPs have the sophistication necessary to complete this underwriting efficiently and have therefore become reliable sources of additional capital. Moreover, many of these LPs also expect co-investment opportunities to be made available on an un-promoted basis (that is, without a carried interest). This is partly because the GPs are seen as being in need of the additional capital, and partly to compensate the LPs for the additional costs attributable to independent underwriting and the increased risk associated with the decreased portfolio diversification associated with co-investments. To these LPs, the blind pool, centrally managed and promoted aspects of side car funds that are so advantageous to the GP may be seen as defeating the raison d'être of a co-investment program.

Nonetheless, many GPs observe that some LPs are repeat customers in participating in co-investments and devote relatively little time to independent underwriting. These repeat co-investors often assert relatively little control over the co-investment process and therefore should find the blind pool aspect of side care funds perfectly acceptable. (Indeed, given the lessened time, expense and fiduciary obligation associated with side car participation, such LPs may characterize the availability of a side car fund as a convenience.) In addition, some LPs share the concern held by the GPs of many mid-size funds that, as acquisition prices continue to escalate, the traditional concentration limits on deal size (most typically, 10% to 20% of committed capital) may be insufficiently generous for their funds to maintain deal flow. Under these circumstances, offering a side car fund to existing LPs may provide the ideal solution. Indeed, the single greatest advantage in setting-up a side car fund is that it can be used to address the funding shortfalls confronted by mid-size funds whose offerings have recently closed but who find themselves coming up short of capital as they compete in the current environment for ever-larger deals at ever-higher prices.

Aligning interests

Side car offerings are most successful when their terms are structured so as to align the interests not just of GPs and LPs, but of the LPs electing to participate in the side car fund and those LPs that exclusively participate in deals through the lead fund. Most private equity funds contain a customary provision to the effect that the sponsor will allocate all attractive investment opportunities to the lead fund rather than competing investment vehicles unless a deal exceeds the fund's concentration limit. Hence, a side car fund will expressly provide that it will have first opportunity after the lead fund's concentration limit is reached. Nonetheless, the sponsor should retain latitude to allocate opportunities among funds on a convenient basis. For example, if a $750 million private equity fund with a 20% concentration limit comes upon a deal requiring $151 million of equity capital, it might make sense to allocate $141 million (rather than $150 million) to the lead fund and $10 million (rather than merely $1 million) to the side car fund. One successful approach is to allocate opportunities to the lead and side car funds on a pro rata basis in accordance with commitments, provided that the lead fund will always have the first opportunity and a minimum allocation (although not necessarily equal to the lead fund's concentration limit). In addition, if the opportunity is not big enough to provide some round number to the side car fund ($10 million, for example), the entire opportunity should be given to the lead fund.

Similarly, the sponsor must take care to set up the side car fund in a manner that does not interfere with any pre-existing obligations to provide co-investment opportunities to particular LPs or to strategic third party investors. In addition, the sponsor should ensure that the side car's terms do not constrain the lead fund from participating in club deals with other financial or strategic investors, notwithstanding the availability of side car capital (if, for example, even larger deals come along or limited investment opportunities are made available by other players). In the context of the largest deals, it is conceivable that, notwithstanding the availability of side car capital, the lead fund may put stress on its concentration limits, and it may be necessary for the lead and side car funds to participate in a club. In any event, because of the potential dilution of opportunity allocation that comes with setting up a side car fund, side car offerings are generally made available only to LPs that are already participating in the lead private equity fund.

The second tier allocation mechanism raises the question of how management fees and carried interests ought to be calculated. Because side car asset management is discretionary and no independent deal-by-deal underwriting by participating LPs is required, side car funds (unlike some co-investment opportunities) are not offered for free. They may charge the standard 20% carried interest (on the theory that the side car fund is simply an adjunct to the lead fund) or they may, as a concession to LPs re-upping to the sponsor shortly after the lead fund offering has been completed, charge a lower carry (perhaps 15% or 10%). The side car fund is not, however, a mere adjunct to the lead fund in that, because it has a right of second opportunity that kicks-in only after the lead fund's appetite for any particular deal has been sated, there is a greater likelihood that the side car's committed capital will never be called down. Accordingly, side car funds sometimes only charge management fees on invested (rather than committed) capital. To attract additional capital, side car management fees can be lower, but are often not subject to set-off by transaction fees, on the basis that the set-off has already been promised to the lead fund.

Side car funds are inexpensive to operate. Because they are generally offered only to LPs that are already participating in the lead fund, side cars have low organizational costs. Because side cars have only a right of second opportunity to deal flow, side cars generally only bear the expenses of completed transactions. Accounting and audit expenses are typically borne separately by the lead and side car funds, on a pro rata basis in respect of co-invested capital. Similarly, because side car funds assemble different portfolios from (although they are sub-set portfolios of) their lead private equity funds, the distribution waterfall on the basis of which a side car's carry is determined is generally separate and apart from that of the lead fund. LPs sometimes object to this, arguing that the performance of their assets under management with a particular GP should be calculated on a unified basis. Nonetheless, because carry, when charged on co-investments, is not traditionally subject to being calculated on the basis of portfolio-wide performance, GPs have successfully resisted this request.

To minimize conflicts of interest between the lead and side car funds, the side car should co-invest in (and, it must be remembered, exit from) each portfolio company as to which it is allocated an opportunity on a pari passu basis. Ideally, the side car should reserve enough available capital to participate in follow-on investments, including down rounds. One disadvantage of side car funds (as opposed to traditional co-investments that are independently underwritten by the participating LPs) is that side car funds have defined aggregate capital commitments that may be exhausted before or after the capital commitments of their lead funds. GPs should be cautious about allocating opportunity size and tranche-out capital on a basis that leaves the lead and side car funds with commensurate amounts of unused capital for use in follow-ons. In case the lead and side car funds fall out of synch with respect to the availability of remaining unfunded commitments in light of the anticipated need for follow-on capital, there should either be an explicit mechanism to obtain a waiver from the general requirement that the funds invest pro rata or explicit permission for the GP to seek follow-on equity capital from other sources, in which case a sub-set of LPs can put forward additional capital. If the follow-on investment is a down round investment that involves the purchase of a senior security, the potential conflicts for the sponsor, who has fiduciary obligations to both the lead fund and the side car fund, will be magnified. Consequently, GPs may want to consider creating separate mechanisms governing up round follow-on investments and down round follow-on investments.

Because it is unduly cumbersome to maintain two advisory boards and side car LPs are typically already participants in the lead fund, conflict waivers ought generally to be resolved by the lead fund's advisory board. Accordingly, the side car fund should contain a provision by which, subject to applicable laws, the LPs in the side car expressly waive conflicts of interest between the GP and the LPs of both funds, taken together as a class, that have been approved by the advisory board of the lead fund. Lead fund advisory board members ought therefore to enjoy appropriate exculpations under the side car fund's governing documents. The explicit mechanism for allocating investment opportunities discussed above and the requirement that investments in which the side car fund does participate should be made (and exited) on a pari passu basis should, taken together, help avoid most conflicts of interest between the lead and side car funds. To the greatest extent possible, any remaining conflicts between the lead and side car fund ought to be explicitly resolved in favour of the lead fund. The requirement that only LPs in the lead fund will be eligible to participate in the side car fund should mitigate the impact of any remaining conflicts.

Similarly, key person and other provisions triggered by events affecting the GP must be co-ordinated properly between the two funds. If the governance provisions of the side car fund are merely independently operative replicants of the provisions of the lead fund, it is possible that, for example, the investment period of one of the funds is terminated while that of the other continues. If, under certain circumstances, a fund's governing documents permit the removal of the GP upon the vote of the LP's and the respective LP's of the lead and the side car funds vote for different results, the two vehicles may fall under different management. To be safe, the governance of the side car ought to be explicitly subject to coordination with the governance of the lead fund.

Viability of separate vehicles

There are, however, crucial ways in which the two vehicles must be administered separately. They should not commingle funds and they should maintain separate books of account and distribution waterfalls, lest they be deemed to be one partnership for various tax, regulatory and/or organizational law purposes. Although lead and side car funds should enjoy the benefits of management agreements with the same fund sponsor, under several scenarios they technically should have separate GP entities (although these entities should be identical to one another).

It is also crucial to remember that, if the vehicles need to qualify as venture capital operating companies (VCOCs) or real estate operating companies (REOCs) under the US Employee Retirement Income Security Act (Erisa), each of the lead fund and the side car fund must have its own direct, contractual and independently exercisable management rights in respect of the portfolio company investments that are relied upon as being qualifying for these purposes. Alternatively, it may be determined that, because one fund has substantial participation by benefit plan investors and the other does not, only one of the funds needs to maintain and exercise these direct contractual management rights. If a fund has any US investors, the application of these regulatory exemptions should be carefully monitored by fund counsel with expertise in Erisa.

Bonus advantage

One additional advantage of setting-up a side car fund over raising multiple co-investment vehicles is that it reduces the number of clients a fund sponsor is deemed to have for purposes of the registration requirements under the US Investment Advisers Act of 1940. Very generally, private equity fund sponsors not holding themselves out to the public in the US as providing investment advice and having fewer than 15 clients are not required to register as investment advisers with the US Securities and Exchange Commission. For purposes of this client count, each private equity fund under management is generally counted as one client (although co-investment and alternative investment vehicles under management are counted separately, and hedge funds and other vehicles issuing redeemable securities will soon be subject to look-through rules under which each constituent investor is treated as a separate client). Many private equity fund sponsors managing their fourth, fifth or sixth generation fund, some of which have alternative investment vehicles, parallel funds and co-investment vehicles under management (not to mention affiliated funds dedicated to different asset classes) are coming up against the 15-client threshold to registration. Private equity fund sponsors that are not yet subject to registration but that have limited headroom left before they reach the threshold may find the use of a blind-pool side car fund to be a useful alternative to the prospect of raising co-investment vehicles over the life of their current lead fund.

Side car funds bring with them several technical complications and are not a panacea for the challenges of today's mega-deal marketplace. They can, however, provide an attractive alternative to fund sponsors seeking to reduce their participation in club deals, and especially for those who do not believe they have a mix of LPs that are ready, willing and able to provide the necessary magnitude of co-investment capital within critical time constraints. Side cars work best for mid-sized funds looking to top-up their availability of unfunded capital. If lead fund documentation is well drawn, blind-pool side car co-investment capital can often be brought under management with minimal (or sometimes no) amendments or LP consent requirements. Under all circumstances, the decision to proceed with a side car fund-raise should be made in consultation with experienced counsel. With a little luck, elegant solutions can be found that maximize the flexibility available to the fund sponsor while ensuring a healthy alignment of interests with investors whose loyalties have been well-earned.

Author biographies

Joseph A Smith Dewey Ballantine LLP Joseph A Smith is a partner practising in Dewey Ballantine's Private Equity Group, where he represents fund sponsors, asset managers, pension funds and endowments in connection with the creation of investment vehicles, the acquisition of portfolio investments and the implementation of exit strategies. In this capacity, he advises clients on securities, governance, Erisa, Investment Advisers Act and structural issues. He has extensive experience with all classes of alternative assets, including funds-of-funds, venture capital and later-stage growth equity investments, leveraged buyouts, mezzanine investments, real estate, distressed debt and hedge funds. In addition to domestic representations, he has advised private equity clients in connection with the acquisition and structuring of portfolio company investments throughout Europe, Latin America and Asia. His representation of asset managers in the real estate sector includes advice concerning public and private Reit offerings, partnership roll-ups and cross-border investments. Smith was recognized in Chambers USA - America's Leading Lawyers for Business 2005 as a leader in the field of private equity: fund formation. He earned his JD from New York University School of Law and his AB from Columbia College. Edward D Nelson Dewey Ballantine LLP Edward D Nelson's practice focuses on the organization and operation of private investment funds. He has represented a wide variety of private investment funds, including buyout funds, venture capital funds, distressed funds, international funds, real estate funds and hedge funds. He has represented investment funds sponsored by American International Group, Avenue Capital Management, CMS Companies, General Atlantic Partners, Graham Partners, Perseus, LLC, Soros Private Equity Partners and The Wicks Group. Nelson also has significant experience in issues relating to the Securities Act, the Investment Company Act and the Investment Advisers Act. His practice has also included many venture capital, private equity and mergers and acquisition transactions. Nelson is a member of the Committee on Private Investment Funds of the NYC Bar Association. Nelson earned his JD, cum laude, from Harvard Law School, earned his Masters from Harvard's JFK School of Government, earned his M Phil from the University of Cambridge, and earned his BA, magna cum laude, from Dartmouth College.