Co-investment is easy to describe when there is enough capacity for everyone. The difficult questions begin when there is not.
A flagship fund may want the full opportunity. An investor may have negotiated co-investment consideration. A strategic participant may improve the deal. A special-purpose vehicle may be needed to complete the financing. An earlier fund may need follow-on capital, while a successor fund is already investing. Members of the manager’s team may also have personal investment rights.
These interests can be legitimate and still conflict. A defensible process for co-investment allocation conflicts must explain which accounts are eligible, which factors influence allocation, who decides, and how the manager records departures from its normal approach. Broad discretion in the LPA is not, by itself, an allocation process.
Start by separating two allocation decisions
Managers often use “co-investment allocation” to describe related but distinct questions.
The first is allocation among client accounts: how much of an investment belongs to the flagship fund, an earlier or successor fund, a separately managed account, or another vehicle managed by the sponsor. The second is syndication of capacity that will not be held by those accounts: which existing investors, third parties, affiliates, or employees may participate in a co-investment vehicle.
The legal duties, contractual rights, and commercial considerations may differ at each stage. A manager should not reduce the flagship fund’s allocation to create fee-generating co-investment capacity without analyzing the conflict. It also should not assume that a promise to “consider” an LP for co-investments gives that LP priority over the fund or other eligible clients.
The governing documents and disclosures should state the intended relationship. If the flagship fund ordinarily receives priority up to a concentration or diversification limit, the policy should reflect that position. If the manager retains discretion to bring in strategic investors before offering capacity more broadly, the fundraising materials should not promise a mechanical pro rata program.
Define eligibility before an attractive deal arrives
An allocation policy should identify the accounts and persons that may receive investment opportunities and the conditions that make each eligible. Relevant factors can include:
- investment mandate and legal restrictions;
- available capital and reserves;
- portfolio construction and concentration;
- investment size and minimum participation;
- timing of the fund’s investment period;
- follow-on obligations and existing exposure;
- tax, regulatory, or structural constraints;
- ability to fund on the required schedule;
- strategic value to the transaction; and
- contractual or side-letter rights.
The policy should explain how factors interact without pretending that every decision can be reduced to a formula. For example, remaining capital is relevant, but it does not necessarily entitle a fund to an investment that would breach its concentration limit. A side letter may require good-faith consideration, not a guaranteed allocation. A strategic investor may add value, but that rationale should not become a label attached after the manager has selected a favored participant.
Eligibility should be assessed before performance is known. A process that places successful investments in the flagship vehicle while leaving failed diligence costs or weaker opportunities elsewhere creates an obvious concern.
Follow-ons expose conflicts between fund generations
Successor funds create one of the most sensitive allocation settings. An existing portfolio company may need new capital after the earlier fund’s investment period has ended or when its reserves are limited. The opportunity may fit the successor fund’s strategy, but investing can transfer value, information, or control between client accounts managed by the same sponsor.
The manager should consider whether the earlier fund may or must participate, whether the successor fund is permitted to invest, how price and terms were established, whether another investor led the round, and whether advisory-committee or other approvals are required. If one fund sells to another or the vehicles invest on different terms, additional conflict analysis may be necessary.
The allocation record should address why each fund’s participation is consistent with its mandate and interests. “Both funds wanted exposure” does not explain why one received the preferred security, why the other was diluted, or how the size of each commitment was determined.
The ILPA Principles 3.0 discuss allocation of opportunities and co-investment practices as alignment and transparency issues. They are industry guidance rather than binding rules, but they provide a useful reference point for the questions institutional investors are likely to ask.
Side letters can change the co-investment universe
Co-investment provisions are often drafted with deliberately qualified language. A manager may agree to consider an investor for opportunities, use reasonable efforts to provide access, or offer a stated amount subject to availability, suitability, timing, and other conditions. The exact verbs and qualifications matter.
The side-letter matrix should identify which investors have co-investment rights, the commitment thresholds or status requirements attached to them, the types of transactions covered, and whether the right extends to affiliates. It should also track notice and response deadlines. An allocation process can fail even if the final division is reasonable when an investor who was promised consideration was never included.
MFN elections may add rights after the relevant side letters are signed. Investor relations, the deal team, finance, and counsel therefore need a shared current record. A deal spreadsheet maintained only by the investment team is unlikely to capture all legal qualifications.
Allocate expenses with the opportunity
Co-investment economics are not limited to whether the vehicle pays management fees or carried interest. Diligence, financing, legal, tax, administration, insurance, and broken-deal costs may also need to be divided.
If the flagship fund and co-investors acquire an asset together, the manager should determine how shared costs follow participation and benefit. Costs incurred before the final syndicate is known require particular attention. So do expenses that one participant negotiates away.
In a 2022 action involving a take-private transaction, the SEC found that a private equity adviser allocated a disproportionate share of credit-facility expenses to its fund after third-party co-investors were excused from those expenses, without appropriate disclosure. The adviser repaid more than $3.3 million and paid a penalty. The SEC’s announcement tied the issue to the fund’s organizational documents and the amount investors had agreed to bear.
That action does not establish a single allocation method for every transaction. It illustrates why the co-investment decision and its expense consequences should be reviewed together.
Contemporaneous records distinguish judgment from favoritism
An allocation memorandum does not need to become a lengthy legal opinion for every deal. It should record enough information to show that the manager used its stated process before the outcome was known.
A useful record identifies the opportunity, eligible accounts, available capacity, proposed allocations, material factors, side-letter considerations, decision makers, approvals, and any departure from the policy’s usual method. If the decision changes, the record should explain why—an investor failed to fund, diligence reduced the investment size, a tax issue made one vehicle unsuitable, or the portfolio-construction analysis changed.
The manager should also preserve declines and unfilled capacity. Otherwise, a later review may show only who received the investment, not who was offered it or why the final allocation differed from the original plan.
Personal and employee participation deserves explicit treatment. Even when permitted, allocations to principals or employees can look self-preferential if client demand was not satisfied. The policy should define when insiders are eligible, whether client accounts receive priority, what approvals apply, and how expenses and terms compare.
Disclosures should describe the actual process
Conflicts disclosure often becomes less useful as it becomes broader. A statement that the manager “may allocate opportunities among clients in its discretion” identifies the existence of discretion but tells an investor little about how the fund is expected to be treated.
The PPM and DDQ should accurately describe the relevant account universe, the manager’s general approach, material preferences or priorities, co-investment economics, and conflicts created by related vehicles. The LPA should provide the authority and governance contemplated by the structure. The policy should guide the internal decision.
Those documents do not need the same level of detail. They should not contradict one another.
The SEC’s 2020 private fund adviser risk alert discussed conflicts involving allocation of investments among clients, co-investments, preferential liquidity rights, and multiple clients investing in the same portfolio company. Its 2022 follow-up included observations involving failures to follow disclosures and policies. These are staff observations, not new legal requirements, but they provide concrete diligence questions for a manager to test.
Review the process across deals, not only within one deal
A single allocation may be reasonable while a pattern tells a different story. Periodic testing should compare allocations across funds, sectors, stages, outcomes, fees, and investor groups. The review can ask whether one vehicle repeatedly receives the most attractive capacity, whether exceptions favor insiders or larger investors, whether broken-deal costs follow the same population as successful opportunities, and whether stated priority rules have been applied consistently.
The SEC’s fiscal year 2026 examination priorities identify allocations, interfund transfers, fees, valuation, disclosures, and differential treatment through side letters among issues that may be relevant in examinations of private fund advisers. Institutional LPs may pressure-test many of the same records for commercial reasons.
The manager does not need to prove that every investor received the result it preferred. It needs to show that the decision followed the fund’s bargain and a process capable of treating competing interests fairly.
Veritas Global advises private fund sponsors on allocation policies, co-investment structures, side-letter rights, conflicts disclosures, and transaction-specific records. If your platform now manages overlapping funds or uses special-purpose vehicles to complete investments, contact us to review whether the allocation process matches the structure.
Disclaimer: This article is provided for general informational purposes only and does not constitute legal, tax, investment, or other professional advice. It does not create an attorney-client relationship. Laws, regulations, guidance, contracts, and market practices may change, and their application depends on specific facts and circumstances. Readers should consult qualified advisers before acting.
