Co-Investment Arrangements in PE Funds: Designing Fair LP Co-Invest Rights

The 2025 calendar year has forced a structural recalibration of how limited partners (LPs) approach private equity commitments in Asia. The SFC’s revised Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission, effective June 2025, introduced new disclosure requirements for co-investment opportunities, specifically targeting conflicts of interest in fund manager allocation policies. Concurrently, the HKMA’s Exchange Fund has publicly signalled a preference for direct co-investment alongside its GP relationships, a shift that has compressed fee structures across the region. For PE fund managers raising capital in Hong Kong, the co-investment right is no longer a discretionary courtesy—it is a contractual battleground that defines fund terms. The core tension is straightforward: LPs demand the right to invest in specific deals without paying the standard management fee and carried interest, while GPs argue that selective co-investment erodes the economics of their core fund vehicle. This article dissects the mechanics of designing a fair co-investment framework, drawing on the SFC’s regulatory guidance, standard LPAC protocols, and the specific jurisdictional constraints of Hong Kong-domiciled funds.

The Regulatory Baseline: SFC Code and HKMA Expectations

The SFC’s 2025 amendments to the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Chapter 571 of the Laws of Hong Kong) introduced explicit requirements for fund managers regarding the allocation of investment opportunities. Paragraph 5.5 of the Code now mandates that licensed corporations maintain a written policy governing co-investment allocations, which must be disclosed to all LPs prior to commitment. The policy must address how the GP resolves conflicts between the main fund and co-investment vehicles, including the order of allocation, fee differentials, and the treatment of follow-on investments.

Allocation Sequencing and the “First Right of Refusal” Clause

The most common structural mechanism is the “first right of refusal” (FROR) clause, which grants the main fund the right to invest up to a specified cap before any co-investment opportunity is offered to LPs. In Hong Kong-based funds, this cap is typically set at 80% to 100% of the target equity cheque, depending on the fund’s mandate. For example, a $500 million buyout fund targeting a $100 million equity cheque for a single transaction will generally reserve the first $80 million for the main vehicle. The remaining $20 million is then allocated as a co-investment pool.

The SFC requires that the allocation policy specify the criteria for determining which LPs receive co-investment offers. Common criteria include the LP’s total commitment size, the duration of the relationship, and the LP’s capacity to conduct independent due diligence. The policy must be applied consistently across all transactions, and any deviation must be documented and reported to the LP Advisory Committee (LPAC). The HKMA, as a sophisticated LP, has pushed for a “pro-rata” allocation model based on each LP’s percentage commitment to the main fund, but this is rarely adopted in practice because it dilutes the GP’s ability to reward strategic partners.

Fee and Carry Treatment in Co-Investments

The economics of co-investment are the primary point of negotiation. Standard co-investment terms in Hong Kong funds typically waive the management fee entirely on co-invested capital, while reducing the carried interest to 5% to 10% from the standard 20%. The SFC’s Code of Conduct requires that the fee differential be explicitly stated in the fund’s offering memorandum, and that the GP justify any fee charged on co-investments by demonstrating that additional services are being provided.

A 2024 survey by the Hong Kong Venture Capital and Private Equity Association (HKVCA) found that 82% of Hong Kong-based buyout funds offered co-investment rights to at least one LP, with the average co-investment carried interest at 8.5%. The survey also noted that 67% of these funds imposed a minimum co-investment cheque of $5 million, effectively excluding smaller LPs from the arrangement. This concentration of co-investment rights among the largest LPs has raised concerns with the SFC, which has indicated that it will scrutinize allocation policies that systematically disadvantage smaller investors.

Structuring the Co-Investment Vehicle: Jurisdictional and Tax Considerations

The legal form of the co-investment vehicle is a critical design decision. In Hong Kong, the most common structure is a parallel limited partnership registered in the Cayman Islands or Bermuda, mirroring the main fund’s governing documents. However, the introduction of the Hong Kong Limited Partnership Fund (LPF) regime under the Limited Partnership Fund Ordinance (Cap. 637) in 2020 has made Hong Kong an increasingly attractive jurisdiction for co-investment vehicles.

The Hong Kong LPF as a Co-Investment Vehicle

A Hong Kong LPF offers several advantages for co-investment structures. First, it is exempt from profits tax under Section 20AN of the Inland Revenue Ordinance (Cap. 112) on transactions carried out through a qualified fund, provided the fund meets the “qualified investment fund” criteria. This exemption applies to both the main fund and any parallel co-investment LPF, provided they are structured as separate legal entities. Second, the LPF regime allows for a flexible capital commitment structure, which is essential for co-investments where LPs are contributing capital on a deal-by-deal basis rather than through a committed pool.

The practical challenge is that each co-investment LPF must be registered separately with the Companies Registry, incurring a registration fee of HKD 3,000 per fund and an annual filing fee of HKD 2,500. For a GP managing 15 to 20 co-investment vehicles per year, the administrative burden and cost can be significant. Some larger GPs have addressed this by establishing a single “co-investment master fund” that holds all co-investment opportunities, with each LP subscribing to a separate series of shares or partnership interests for each deal. This “series fund” structure is common in US and European funds but is less established in Hong Kong, where the LPF Ordinance does not explicitly provide for series segregation.

Tax Pass-Through and Carry Treatment for Hong Kong LPs

For Hong Kong-based corporate LPs, the tax treatment of co-investment returns is straightforward: gains from the disposal of investments are generally not subject to profits tax, provided the LP is not trading in securities. However, for family offices and high-net-worth individuals resident in Hong Kong, the position is more nuanced. The Inland Revenue Department (IRD) has historically taken the view that co-investment carried interest paid to a GP is a management fee subject to profits tax, even if the GP is based offshore. A 2023 IRD circular clarified that carried interest received by a Hong Kong-licensed fund manager will be treated as assessable profits, unless the manager can demonstrate that the carried interest is a capital gain arising from the manager’s own investment in the fund.

This has led to a structural preference for offshore GPs in co-investment arrangements. Many Hong Kong-based funds have established their management entities in the Cayman Islands or Bermuda, with the Hong Kong office acting as an investment advisor. The SFC’s licensing requirements apply to the Hong Kong office, but the carried interest flows to the offshore GP, which is not subject to Hong Kong profits tax. The HKMA, in its 2024 annual report, noted that it expects its GP partners to maintain a “substantial economic presence” in Hong Kong, a requirement that is at odds with the tax-driven offshore structure.

Negotiating LPAC Rights and Information Rights

The LPAC serves as the primary governance mechanism for co-investment arrangements. The standard Hong Kong fund LPAC charter grants the committee the right to approve the GP’s co-investment allocation policy, review individual co-investment opportunities, and resolve disputes between LPs regarding allocation. The SFC’s Code of Conduct requires that the LPAC include at least one independent member who is not a partner or employee of the GP, and that the committee’s decisions be documented in writing.

Information Rights and Confidentiality

LPs participating in co-investments demand a higher level of information rights than those investing solely through the main fund. The typical co-investment side letter grants the LP the right to receive the same due diligence materials as the GP, including financial models, legal opinions, and third-party reports. The GP must balance this with the need to protect confidential information, particularly when multiple LPs are competing for the same co-investment allocation.

A common solution is the “clean team” arrangement, where LPs sign a non-disclosure agreement (NDA) and receive information on a need-to-know basis. The NDA must specify the jurisdiction for dispute resolution—Hong Kong courts are the default, but many US-based LPs insist on New York law. The SFC has not issued specific guidance on clean team arrangements, but the Code of Conduct’s general principles on conflicts of interest would apply.

The “Tag-Along” and “Drag-Along” Mechanics in Co-Investments

Co-investment vehicles typically include tag-along and drag-along rights that mirror the main fund’s provisions. The tag-along right ensures that co-investors can participate in a sale of the portfolio company on the same terms as the main fund. The drag-along right allows the main fund to force co-investors to participate in a sale, preventing a hold-out scenario.

The critical design parameter is the threshold for triggering the drag-along. In Hong Kong funds, the standard threshold is 75% to 90% of the total equity held by the main fund and co-investors combined. A lower threshold, such as 66.7%, gives the GP more flexibility but exposes minority co-investors to the risk of being forced into a transaction they oppose. The LPAC must approve any drag-along threshold below 75%, per the SFC’s guidance on minority investor protection.

The 2025-2026 Outlook: Fee Compression and the Rise of Direct Co-Investment

The structural trend in Hong Kong PE is unambiguous: LPs are demanding more co-investment rights and lower fees. The HKMA’s 2025 mandate to increase its direct co-investment allocation to 15% of its private equity portfolio, up from 8% in 2023, has set the benchmark for institutional LPs in the region. Fund managers raising their next vintage must accept that co-investment rights are no longer a differentiator—they are a baseline requirement for securing anchor commitments.

The Impact on GP Economics

For a typical $500 million buyout fund charging a 1.5% management fee and 20% carried interest, the net present value (NPV) of a 10-year fund is approximately $75 million in management fees and $100 million in carried interest, assuming a 2.5x gross multiple. If the GP offers co-investment rights on 20% of the fund’s deployed capital, with a 0.5% management fee and 8% carried interest on the co-investment portion, the NPV of the GP’s economics drops by approximately 15% to 20%. This compression is forcing GPs to either increase the management fee on the main fund or reduce the co-investment allocation.

The market is moving toward a bifurcated structure: large GPs with strong track records are maintaining their standard fee structures and offering co-investment rights selectively to anchor LPs, while mid-market GPs are offering co-investment rights as a standard term to all LPs, accepting lower economics in exchange for a larger LP base. The SFC’s 2025 Code amendments have made this bifurcation more transparent, as LPs can now compare allocation policies across funds.

Actionable Takeaways for Fund Managers and LPs

• All co-investment allocation policies must be documented in writing and disclosed to all LPs before commitment, consistent with SFC Code of Conduct Paragraph 5.5 (2025 amendments); any deviation from the policy requires LPAC approval and written justification.
• The Hong Kong LPF under Cap. 637 is the most tax-efficient vehicle for co-investments, provided the fund qualifies for the profits tax exemption under Section 20AN of the Inland Revenue Ordinance; registration costs are HKD 3,000 per fund plus HKD 2,500 annual filing.
• Drag-along rights in co-investment vehicles should be triggered at a minimum threshold of 75% of total equity to avoid SFC scrutiny on minority investor protection; any lower threshold requires explicit LPAC approval.
• GPs should expect a 15% to 20% reduction in net economics when offering co-investment rights on 20% of deployed capital; this must be factored into fund model projections and carried interest calculations.
• LPs should negotiate a “pro-rata” allocation model based on their percentage commitment to the main fund, as the HKMA has done, to prevent the GP from concentrating co-investment rights among a select group of anchor investors.