Fiduciary Responsibility in Co-Investments

Understanding Fiduciary Duty in Co-Investments

Fiduciary responsibility—quite a mouthful, right? It simply points to the obligation that one person (or entity) has to act in the best interests of another. When I first encountered the concept, I was a junior analyst grappling with a major co-investment proposal alongside our core private equity fund. It felt a little nerve-racking because co-investments add extra layers of complexity to the usual manager–investor dynamic. Not only do GPs (General Partners) have to optimize returns for their limited partners (LPs), but in co-investment deals, they also need to juggle the demands of an additional, often large, co-investor that might enjoy different fee terms, different risk preferences, or, well, different everything.

This sense of “duty to serve the best interest” intensifies under co-investment structures. Because co-investors often rely heavily on a GP’s diligence, oversight, professional judgment, and fairness, any slip-up may erode trust, dent reputations, and possibly trigger legal liabilities. Meanwhile, LPs (say a pension fund or an endowment) must also ensure that their co-investment decisions remain prudent for their own beneficiaries. So let’s dig into the nuances of how fiduciary duty comes to life in co-investments.

Balancing Conflicts of Interest

Co-investments can be amazing because they let investors tap into the sponsor’s best deals at favorable economics (for instance, reduced or no management fees, reduced carried interest, and so forth). But these sweet deals can come with conflicts:

• Potential for Reduced Diversification: Some co-investments concentrate LP capital in a single opportunity.
• Tension between GP and Different Co-Investors: GPs seeking additional capital might court certain investors more aggressively—sometimes neglecting that not all LPs can accept or desire the same risk exposures.
• Side Arrangements and Special Terms: You’d be surprised how quickly undisclosed side letters or sweetheart deals can show up in a co-investment. Maybe the sponsor quietly arranges some fee discounts or different governance rights for one large investor—potentially to the disadvantage of others.

When conflicts bubble up, they often do so because of incomplete disclosure or misalignment of incentives. That’s why the duty of loyalty and the duty of care loom so large.

Duty of Loyalty and Duty of Care

The duty of loyalty basically says, “You have to put your clients’ (or your beneficiaries’) interests first—always.” It means no self-dealing, no shady side deals, and yes, full transparency. Meanwhile, the duty of care is about prudence and thoroughness in making decisions. If a GP invests in a software start-up without fully investigating the founder’s track record, the product pipeline, or the competitive landscape, they could face questions about whether they truly satisfied their duty of care.

Quick Illustrative Example

Imagine a GP sees a stellar growth opportunity in a biotech firm. They put it into the main fund but also invite co-investors to put in an additional $20 million. If the GP has the inside scoop that the biotech firm’s next clinical trial looks promising, they might be fulfilling their duty of loyalty and care by sharing this opportunity widely across interested LPs—within the guidelines of confidentiality. However, if they only share it with their favorite institutional investor (the one that invests a ton in the fund each year) and withhold it from other LPs who actually inquired about co-investment opportunities, that might violate the fairness principle underlying fiduciary responsibility.

The Role of Disclosure

Full disclosure is the lifeblood of fiduciary responsibility. Nobody wants hidden fees or hush-hush side letters. When co-investors step into a deal, they usually rely on the GP’s due diligence and structuring, which includes:

• Transparent Fee Arrangements: Ensuring that everyone knows who pays what fees, carried interest splits, or ongoing management costs.
• Explicit Conflict of Interest Disclosures: For example, “We, the GP, have a vested interest in this particular real estate project because one of our principals sits on the board of the construction firm.”
• Economic and Governance Terms: Outlining exactly how co-investors share in the upside and the downside.

I once saw a scenario where a GP included ambiguous language in the co-investment memoranda—something along the lines of “additional fees may apply as per sponsor’s discretion.” That is a big no-no under a strong fiduciary framework. Clear, unambiguous disclosures keep all parties from unpleasant surprises and potential litigation.

The Overlapping Responsibilities of GPs and LPs

It’s not just the GP who must wear the fiduciary hat. Large LPs—like pension funds—have their own sets of fiduciary obligations to the pensioners (the real beneficiaries). Picture a pension fund manager who invests in a co-investment opportunity that is way too risky compared to what retirees’ risk profiles can handle. That manager might be breaching their own duty of care to the pensioners. So, prudent investing—aligned with each institution’s risk/return objectives—remains essential, especially for co-investment deals that can be chunky relative to the total portfolio.

Conflict Resolution and Internal Compliance

Okay, so how do we keep co-investment deals on track and not devolve into fiascos? It comes down to establishing a robust internal compliance program and clarifying conflict resolution processes.

• Create a Dedicated Conflict Resolution Committee: A group within the GP’s organization or the LP’s internal governance that flags potential conflicts early.
• Written Policies: Document how the GP prioritizes deals for the main fund vs. co-investors. Maybe the policy says all co-investment opportunities must be offered pro rata to existing LPs.
• Periodic Audits or Third-Party Verification: Engaging external auditors or third-party consultants to double-check that co-investments are fairly allocated and not used to offload risk.

Here’s a diagram that visualizes how various entities (GP, Main Fund, Co-Investors) might be linked and how conflicts can arise:

    flowchart LR
	    A["General Partner <br/>(GP)"] --> B["Main Fund <br/>(Portfolio)"]
	    B --> C["Co-Investment <br/>Opportunity"]
	    C --> D["Limited Partner <br/>(LP)"]
	    A --> E["Conflict Resolution <br/>Committee or Policy"]
	    E --> D

In this simplified flow, the GP drives the main fund and decides when to spin off co-investment opportunities. A conflict resolution committee (or policy mechanism) stands by to ensure fair and transparent allocation processes. Meanwhile, each LP invests in the main fund or in direct co-investment deals.

Glossary

Fiduciary
An individual or entity legally obligated to act in another party’s best interest (e.g., a trustee for a pension fund, GP for an LP).

Duty of Loyalty
The requirement to put client or beneficiary interests ahead of personal considerations.

Side Arrangements
Unofficial or selectively shared agreements granting special rights or fee structures to certain investors. These must be disclosed to avoid ethical and legal pitfalls.

Disclosure
Full transparency over all deal terms, potential conflicts, and any special agreements or fees.

Internal Compliance
An internal set of policies and processes ensuring that all decisions follow legal, ethical, and regulatory guidelines.

Duty of Care
The responsibility to undertake careful, well-researched, and prudent decision-making, especially important in illiquid and complex co-investment scenarios.

Conflicts of Interest
Any situation—financial, personal, or otherwise—where an individual’s or firm’s decisions might be biased due to competing incentives.

Beneficiaries
People or entities that ultimately receive the profits or benefits from investments. For a pension fund, these would be retirees; for a foundation, the philanthropic endeavors, etc.

Personal Reflection and Practical Example

I recall a case at a small private equity shop where I worked as an analyst. The GP had a golden co-investment opportunity in a niche manufacturing firm. Because it was so specialized, few major LPs expressed interest. But the sponsor wanted to secure co-investments quickly to reduce the main fund’s exposure. So they reached out to one large LP with whom they had a strong relationship.

Midway through diligence, it turned out the manufacturing firm’s primary customer was run by a close relative of one of the GP’s principals. This nepotism angle wasn’t initially disclosed to smaller co-investors. The GP was facing a serious duty of loyalty issue by not presenting the potential conflict up front. In the end, the sponsor came clean, provided the relevant documents, and allowed each LP to decide whether to proceed. Luckily, the manufacturing firm’s related-party relationships did not hamper returns. But had the conflicts not been shared promptly, the GP could have faced a breach of fiduciary duty claim or possibly a meltdown of investor confidence.

Best Practices for Maintaining Fiduciary Responsibilities

Exam Tips and Common Pitfalls

• Keep an Eye on Disclosures: For CFA exam scenarios, expect queries on how to handle incomplete or inadequate disclosures in co-investment deals.
• Dual Fiduciary Roles: Watch out for questions where a pension fund is the LP, as they also have fiduciary duties to their beneficiaries.
• Recognize Conflict Red Flags: The exam might test your ability to identify or mitigate hidden conflicts of interest.
• Alignment with Ethics: Always connect fiduciary duties back to the CFA Institute Code of Ethics and Standards of Professional Conduct.
• Procedure for Conflicts: Be prepared to describe steps a GP or an LP can take to resolve or disclose a conflict (e.g., establishing an independent committee, recusal of certain individuals).

References

• Institutional Limited Partners Association (ILPA) Guidelines: Offers best practices on governance, transparency, and fiduciary responsibility.
• CFA Institute Code of Ethics and Standards of Professional Conduct: https://www.cfainstitute.org/en/ethics-standards
• Additional Reading:
– “Private Equity and Co-Investment Strategies,” CFA Institute Publication
– “Limited Partnership Agreements: A Legal Perspective,” Johns, M. & Harper, D. (2022)

Test Your Knowledge: Fiduciary Responsibilities in Co-Investments