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Key considerations for follow-on
co-investments in today’s market

March 5, 2024 | 6 min read

Investors in recent years have been drawn to co-investing for its potential to generate outperformance at reduced costs, as well as the opportunity it brings to be more actively involved in managing their portfolios. In today’s more volatile macro backdrop with more constrained liquidity, the level of co-investment follow-on activity is rising and playing a crucial role in a company’s financing while offering investors an opportunity to gain greater exposure to high caliber assets with attractive pricing and terms.
In the Q&A below, we explore the trends driving opportunities across the co-investment landscape and some of the important considerations for investors as they look at making strategic follow-on commitments to existing portfolio companies.

Gonçalo Faria Ferreira

Managing Director

What are follow-on investments and why do investors contribute more capital post initial investment?

A follow-on investment is an additional investment made into an existing portfolio company. Follow-on investments can be classified into one of two categories: offensive or defensive. Offensive follow-on capital typically includes investments to support accretive acquisitions or fund growth initiatives. Defensive investments, on the other hand, are normally made to support businesses not performing to plan, either because of unexpected declines in business performance or because of capital structures that become challenged due to market conditions. 

Regardless of the classification of the follow-on investment, the commitment can take many different forms including common equity, preferred equity, or debt. It can also be structured as temporary capital or permanent capital. Importantly, each situation is unique, and the structure of the investment can be tailored to match the specific needs of the business and its investors. Most importantly, investors need to ensure that any incremental capital invested has an identifiable and acceptable ROI, and that they are not “throwing good money after bad.”

What about the market environment has led to an uptick in follow-on investment activity?

Private markets investors have been forced to confront liquidity challenges created by a confluence of macroeconomic and geopolitical events that have destabilized global capital markets over the past few years. For those reasonably capitalized, the challenges and uncertainty have created buying opportunities, wherein a buyer is often able to purchase high-quality assets with favorable pricing and terms. For those less well situated, liquidity concerns have forced investors, including co-investors, to make difficult and sometimes rapid decisions to protect their investments in portfolio companies. As traditional lending sources have become more constrained in the current environment, follow-on capital is often filling the gap and providing a flexible and efficient solution for general partners (GPs) and portfolio companies. Notably, as macro conditions and uncertainty deepened beginning in 2022, there has been a meaningful rise in follow-on activity. And, as market volatility and higher interest rates have persisted through 2023 and into early 2024, there is growing evidence of a rise in defensive strategies.1

What are some of the key considerations for investors thinking about a co-invest follow on commitment?

When evaluating a follow-on investment opportunity, it is important to have a consistent and replicable approach to evaluating each opportunity. That approach often starts with effective portfolio monitoring which allows investors to be both current and knowledgeable about the investments in their portfolio. Key to the decision-making process is knowing the right questions to ask, and while not a comprehensive list, the questions can be simplified into three broad categories.

First, alignment of interests and incentives, which is critical for both new and follow-on investments. Is the leadership team of the portfolio company and the GP leading the investment participating in the follow-on proportionally and continuing to support the business, not just with financial capital, but also with human and intellectual capital? If the management incentive plan (MIP) in the company or carried interest in the GP’s fund is out of money with no realistic expectation of recovering, will they continue to work on your behalf to drive for a successful outcome? If not, does the incentive structure require a revision to ensure appropriate alignment and incentives that will drive toward a mutually successful outcome?

Next, capital structure and liquidity. Does the follow-on investment proposal provide the needed liquidity for the short-term while also considering the longer-term needs of the business? If not, should the investor encourage the leaders of the business to consider a more comprehensive solution rather than applying a so-called “band-aid” approach? If the follow-on is more “defensive” in nature, seeking to manage a liquidity situation or to right-size an upside-down capital structure, are all investors – both debt and equity – shouldering the burden? Creditors should also be incentivized to protect their capital and encouraged to make concessions where necessary and appropriate to increase the likelihood of the business’ survival and capital preservation for themselves.

Finally, penalties for not participating or “pay to play” dynamics. What are the consequences of not participating within a follow-on? It is important to understand and model the consequences of not participating in a follow-on investment. In an offensive follow-on, the consequences are typically limited to the investor having their stake diluted and missing out on an opportunity to invest incremental capital into a known business generating strong returns. In defensive follow-ons, however, it is important to also understand whether there are any “penalties” for not participating. These can take the form of the investor losing their investment preference, or otherwise becoming subordinated in the capital structure to the new capital. In certain cases not participating means that the investor loses their entire initial capital investment.

Co-investing is often thought of as a passive strategy. Is that accurate?

No, co-investing can be passive or active. Passive co-investing within a syndication-focused approach entails participating in investment opportunities alongside other investors without actively engaging in the execution and monitoring of the investments. In this model, investors rely heavily on the expertise and resources of the syndication lead or manager to identify, execute, and oversee investment opportunities. The passive co-investor does not dedicate specific resources or personnel to oversee the investments independently, and instead rely on the syndication lead to act in their best interests and generate returns on their behalf. While passive co-investing offers the benefit of diversification and access to deals that an individual investor may not have access to on their own, it also entails relinquishing control over the investment process and outcomes. Thus, it’s crucial for passive co-investors to thoroughly vet the syndication lead and understand the investment strategy and risk profile before committing capital.

Conversely, active co-investing is characterized by investors actively participating in identifying, evaluating, and making investment decisions alongside other investors. Active co-investors often collaborate closely with management teams, conduct due diligence, and contribute their expertise to enhance the success of the investments. Active co-investors typically have a more hands-on approach in due diligence, often as a co-underwriter, and may play a significant role in shaping the direction and outcomes of their investments. In some cases, co-investors take on a deeper governance role either as a board member or board observer to create greater engagement with the portfolio company management team, obtain more timely information, or ultimately, create a higher degree of influence on decision-making. Firms that take an active approach to co-investing, like HarbourVest, benefit from advantages including control and influence, alternative solutions, and alignment of interests.

What trends are impacting follow-on investments and what do they mean for co-investments going forward?

The largest follow-on trends in today’s market center on merger and acquisition opportunities and capital structure. In terms of M&A, we are seeing well-capitalized businesses with strong balance sheets taking advantage of market dislocation to acquire companies at attractive valuations, often at lower multiples than the initial transaction to acquire the platform company. With operationally focused GPs, this strategy has the potential to create meaningful value, not simply through multiple arbitrage, but through efficiencies and earnings accretion as a result of a successful integration. In more volatile market environments, history and experience suggest the strong get stronger. 

The flip side of the coin is that the credit environment has made it more challenging for businesses with leveraged capital structures. The unprecedented rise in interest rates has led to high debt service requirements, and companies that hit a bump in the road operationally, or even those that are growing more slowly than anticipated, are finding it more challenging to operate and invest in growth. This has led to, on balance, more liquidity-based follow-on transactions in an effort to provide companies with breathing room to continue to execute on their long-term strategies. 

Key takeaways

Against today’s macro backdrop, whether making an initial investment or injecting additional capital into an existing business, it is critical for investors to ensure their capital is being allocated toward its highest and best use. Although co-investors typically seek to maintain alignment with the lead sponsors, in certain instances, likeminded investors may come to different conclusions based on assessing tradeoffs of supporting one portfolio company at the expense of another and their distinct investment objectives and risk profile.

  • Follow-on decisions are highly nuanced requiring both a structured and methodical evaluation approach to ensure an optimized outcome and the ability to make swift decisions.
  • Active portfolio monitoring of the investment portfolio and its potential future capital needs helps investors make more informed decisions quickly while also ensuring the appropriate prioritization of limited capital in the context of a diversified investment portfolio. 
  • For less experienced or under resourced investors, it can be difficult to develop the necessary pattern recognition or have the capacity to evaluate these opportunities in the timelines required; particularly when limited resources hamper active portfolio monitoring.
  • Selecting an experienced partner that possesses the expertise, historical experience, and capacity to independently evaluate follow-on investment opportunities can help investors navigate the complexities and shortened timeframes that are typical with follow-on commitments.

Would you like to discuss co-investing and how we approach follow-on opportunities?

Contact us
Footnotes

1. HarbourVest, as of December 31, 2023.

Disclosure

HarbourVest Partners, LLC is a registered investment adviser under the Investment Advisers Act of 1940. This material is solely for informational purposes and should not be viewed as a current or past recommendation or an offer to sell or the solicitation to buy securities or adopt any investment strategy. The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication, are not definitive investment advice, and should not be relied upon as such. This material has been developed internally and/or obtained from sources believed to be reliable; however, HarbourVest does not guarantee the accuracy, adequacy, or completeness of such information. There is no assurance that any events or projections will occur, and outcomes may be significantly different than the opinions shown here. This information, including any projections concerning financial market performance, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. The information contained herein must be kept strictly confidential and may not be reproduced or redistributed in any format without the express written approval of HarbourVest.

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Professional Investor Definition

“Professional Investor” under the Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) (the “SFO”) and its subsidiary legislation) means:

(a) any recognised exchange company, recognised clearing house, recognised exchange controller or recognised investor compensation company, or any person authorised to provide automated trading services under section 95(2) of the SFO;

(b) any intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong;

(c) any authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong;

(d) any insurer authorized under the Insurance Ordinance (Cap. 41 of the Laws of Hong Kong), or any other person carrying on insurance business and regulated under the law of any place outside Hong Kong;

(e) any scheme which-

(i) is a collective investment scheme authorised under section 104 of the SFO; or

(ii) is similarly constituted under the law of any place outside Hong Kong and, if it is regulated under the law of such place, is permitted to be operated under the law of such place,

or any person by whom any such scheme is operated;

(f) any registered scheme as defined in section 2(1) of the Mandatory Provident Fund Schemes Ordinance (Cap. 485 of the Laws of Hong Kong), or its constituent fund as defined in section 2 of the Mandatory Provident Fund Schemes (General) Regulation (Cap. 485A of the Laws of Hong Kong), or any person who, in relation to any such registered scheme, is an approved trustee or service provider as defined in section 2(1) of that Ordinance or who is an investment manager of any such registered scheme or constituent fund;

(g) any scheme which-

(i) is a registered scheme as defined in section 2(1) of the Occupational Retirement Schemes Ordinance (Cap. 426 of the Laws of Hong Kong); or

(ii) is an offshore scheme as defined in section 2(1) of that Ordinance and, if it is regulated under the law of the place in which it is domiciled, is permitted to be operated under the law of such place,

or any person who, in relation to any such scheme, is an administrator as defined in section 2(1) of that Ordinance;

(h) any government (other than a municipal government authority), any institution which performs the functions of a central bank, or any multilateral agency;

(i) except for the purposes of Schedule 5 to the SFO, any corporation which is-

(i) a wholly owned subsidiary of-

(A) an intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong; or

(B) an authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong;

(ii) a holding company which holds all the issued share capital of-

(A) an intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong; or

(B) an authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong; or

(iii) any other wholly owned subsidiary of a holding company referred to in subparagraph (ii); or

(j) any person of a class which is prescribed by rules made under section 397 of the SFO for the purposes of this paragraph as within the meaning of this definition for the purposes of the provisions of the SFO, or to the extent that it is prescribed by rules so made as within the meaning of this definition for the purposes of any provision of the SFO.

The first of such classes of additional “professional investor”, under the Securities and Futures (Professional Investor) Rules (Cap. 571D of the Laws of Hong Kong), are:

(k) any trust corporation (registered under Part VIII of the Trustee Ordinance (Cap. 29 of the Laws of Hong Kong) or the equivalent overseas) having been entrusted under the trust or trusts of which it acts as a trustee with total assets of not less than HK$40 million or its equivalent in any foreign currency at the relevant date (see below) or-

(i) as stated in the most recent audited financial statement prepared-

(A) in respect of the trust corporation; and

(B) within 16 months before the relevant date;

(ii) as ascertained by referring to one or more audited financial statements, each being the most recent audited financial statement, prepared-

(A) in respect of the trust or any of the trust; and

(B) within 16 months before the relevant date; or

(iii) as ascertained by referring to one or more custodian (see below) statements issued to the trust corporation-

(A) in respect of the trust or any of the trusts; and

(B) within 12 months before the relevant date;

(l) any individual, either alone or with any of his associates (the spouse or any child) on a joint account, having a portfolio (see below) of not less than HK$8 million or its equivalent in any foreign currency at the relevant date or-

(i) as stated in a certificate issued by an auditor or a certified public accountant of the individual within 12 months before the relevant date; or

(ii)  as ascertained by referring to one or more custodian statements issued to the individual (either alone or with the associate) within 12 months before the relevant date;

(m) any corporation or partnership having-

(i) a portfolio of not less than HK$8 million or its equivalent in any foreign currency; or

(ii) total assets of not less than HK$40 million or its equivalent in any foreign currency, at the relevant date, or as ascertained by referring to-

(iii) the most recent audited financial statement prepared-

(A) in respect of the corporation or partnership (as the case may be); and

(B) within 16 months before the relevant date; or

(iv) one or more custodian statements issued to the corporation or partnership (as the case may be) within 12 months before the relevant date; and

(n) any corporation the sole business of which is to hold investments and which at the relevant date is wholly owned by any one or more of the following persons-

(i) a trust corporation that falls within the description in paragraph (k);

(ii) an individual who, either alone or with any of his or her associates on a joint account, falls within the description in paragraph (k);

(iii) a corporation that falls within the description in paragraph (m);

(iv) a partnership that falls within the description in paragraph (m).

For the purposes of paragraphs (k) to (n) above:

  • “relevant date” means the date on which the advertisement, invitation or document (made in respect of securities or structured products or interests in any collective investment scheme, which is intended to be disposed of only to professional investors), is issued, or possessed for the purposes of issue;
  • “custodian” means (i) a corporation whose principal business is to act as a securities custodian, or (ii) an authorised financial institution under the Banking Ordinance (Cap. 155 of the Laws of Hong Kong); an overseas bank; a corporation licensed under the SFO; or an overseas financial intermediary, whose business includes acting as a custodian; and
  • “portfolio” means a portfolio comprising any of the following (i) securities; (ii) certificates of deposit issued by an authorised financial institution under the Banking Ordinance (Cap, 155 of the Laws of Hong Kong) or an overseas bank; and (iii) except for trust corporations, cash held by a custodian.

Institutional Investor / Accredited Investor Definition

An institutional investor as defined in Section 4A of the SFA and Securities and Futures (Classes of Investors) Regulations 2018 is:

(a) the Singapore Government;

(b) a statutory board as may be prescribed by regulations made under section 341 of the SFA, as prescribed in the Second Schedule of the Securities and Futures (Classes of Investors) Regulations 2018;

(c) an entity that is wholly and beneficially owned, whether directly or indirectly, by a central government of a country and whose principal activity is —

(i) to manage its own funds;

(ii) to manage the funds of the central government of that country (which may include the reserves of that central government and any pension or provident fund of that country); or

(iii) to manage the funds (which may include the reserves of that central government and any pension or provident fund of that country) of another entity that is wholly and beneficially owned, whether directly or indirectly, by the central government of that country;

(d) any entity —

(i) that is wholly and beneficially owned, whether directly or indirectly, by the central government of a country; and

(ii) whose funds are managed by an entity mentioned in sub‑paragraph (c);

(e) a bank that is licensed under the Banking Act 1970;

(f) a merchant bank that is licensed under the Banking Act 1970;

(g) a finance company that is licensed under the Finance Companies Act 1967;

(h) a company or co‑operative society that is licensed under the Insurance Act 1966 to carry on insurance business in Singapore;

(i) a company licensed under the Trust Companies Act 2005;

(j) a holder of a capital markets services licence;

(k) an approved exchange;

(l) a recognised market operator;

(m) an approved clearing house;

(n) a recognised clearing house;

(o) a licensed trade repository;

(p) a licensed foreign trade repository;

(q) an approved holding company;

(r) a Depository as defined in section 81SF of the SFA;

(s) a pension fund, or collective investment scheme, whether constituted in Singapore or elsewhere;

(t) a person (other than an individual) who carries on the business of dealing in bonds with accredited investors or expert investors;

(u) a designated market‑maker as defined in paragraph 1 of the Second Schedule to the Securities and Futures (Licensing and Conduct of Business) Regulations;

(v) a headquarters company or Finance and Treasury Centre which carries on a class of business involving fund management, where such business has been approved as a qualifying service in relation to that headquarters company or Finance and Treasury Centre under section 43D(2)(a) or 43E(2)(a) of the Income Tax Act 1947;

(w) a person who undertakes fund management activity (whether in Singapore or elsewhere) on behalf of not more than 30 qualified investors;

(x) a Service Company (as defined in regulation 2 of the Insurance (Lloyd’s Asia Scheme) Regulations) which carries on business as an agent of a member of Lloyd’s;

(y) a corporation the entire share capital of which is owned by an institutional investor or by persons all of whom are institutional investors;

(z) a partnership (other than a limited liability partnership within the meaning of the Limited Liability Partnerships Act 2005) in which each partner is an institutional investor.

An accredited investor as defined in Section 4A of the SFA and Securities and Futures (Classes of Investors) Regulations 2018 is:

(i)  an individual —

(A) whose net personal assets exceed in value $2 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;

(B) whose financial assets (net of any related liabilities) exceed in value $1 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount, where “financial asset” means —

(BA) a deposit as defined in section 4B of the Banking Act 1970;

(BB) an investment product as defined in section 2(1) of the Financial Advisers Act 2001; or

(BC) any other asset as may be prescribed by regulations made under section 341; or

(C) whose income in the preceding 12 months is not less than $300,000 (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;

(ii)  a corporation with net assets exceeding $10 million in value (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe, in place of the first amount, as determined by —

(A) the most recent audited balance sheet of the corporation; or

(B) where the corporation is not required to prepare audited accounts regularly, a balance sheet of the corporation certified by the corporation as giving a true and fair view of the state of affairs of the corporation as of the date of the balance sheet, which date must be within the preceding 12 months;

(iii) A trustee of a trust which all the beneficiaries are accredited investors; or

(iv) A trustee of a trust which the subject matter exceeds S$10 million; or

(v) An entity (other than a corporation) with net assets exceeding S$10 million (or its equivalent in a foreign currency) in value. “Entity” includes an unincorporated association, a partnership and the government of any state, but does not include a trust; or

(vi) A partnership (other than a limited liability partnership) in which every partner is an accredited investor; or

(vii) A corporation which the entire share capital is owned by one or more persons, all of whom are accredited investors.

Continuation solutions encompass a host of transaction types in which a GP secures interim liquidity and/or additional primary capital for their LPs in a strongly performing asset, or set of assets, that the GP will continue to own and control. Specifically, they include continuation funds, new funds created by GPs for the purpose of acquiring the asset(s) that continue to be managed by the same GP and capitalized by one or several secondary buyers, or equity recapitalizations involving a direct equity or structured equity investment into a portfolio company. These transactions can also include a parallel investment from the GP’s latest fund into that same pool of assets (a “cross-fund trade”).