Co-investment rights in MENA venture capital: a strategic framework for limited partners

Abdullah Mutawi

Partner and Head of Corporate, MENA

Fawaz Elmalki

Senior Counsel

Luna Shehayeb

Associate

While the MENA private equity landscape has witnessed a fundamental shift in limited partner (LP) expectations in the private equity fund investing space, with co-investment rights emerging as a critical requirement for institutional and family office fund commitments, co-investing with venture capital (VC) funds presents unique considerations.

VC investors typically allocate their capital across more numerous early-stage companies to diversify portfolio risk inherent in startup investing. Despite this diversification strategy, many VC investors are recognising that co-investing allows for targeted exposure to the most promising start-ups while benefiting from the VC manager's expertise and transactional capabilities, as well as the ability to concentrate capital in high-conviction opportunities. This is particularly compelling in the technology sector, where the potential for exponential returns can justify concentrated exposure to exceptional opportunities.

In this article, we examine the strategic framework for implementing co-investment rights in the MENA VC fund space, exploring structural considerations, essential protections, and the evolution of co-investment as a distinct product offering.

Understanding co-investment structures from an LP perspective

Co-investments represent direct investments by LPs in specific opportunities alongside, but distinct from, the VC manager's fund. Co-investors are typically institutional investors and family offices who have made significant capital contributions to the main VC fund, though co-investment opportunities may also be extended to parties who are not existing fund investors.

A co-investment vehicle serves as a strategic tool employed by VC managers in several key scenarios. For example, when a particular investment opportunity exceeds the fund's capacity or concentration limits, a co-investment structure allows the VC manager to pursue larger deals whilst maintaining appropriate diversification within the main fund. A co-investment vehicle may also enable the participation of strategic limited partners whose involvement can significantly enhance the investment opportunity through industry expertise, market access, operational synergies, or validation of the investment thesis.

Unlike traditional fund investments, co-investments allow LPs to participate directly in individual portfolio companies, providing several compelling advantages that have made them increasingly attractive to sophisticated VC investors seeking exposure to high-growth technology companies.

The benefits of co-investing for LPs in the VC space include the following.

Enhanced economic returns

Co-investors benefit from VC-managed deals with discounted fees. Co-investments typically feature reduced or eliminated management fees and carried interest, significantly improving blended returns across an LP's VC allocation. This fee advantage is particularly valuable in VC investing due to the J-curve effect, the typical pattern where VC funds initially show negative returns in their early years due to management fees, conservative valuations, and early-stage company failures, before recovering and generating substantial positive returns as portfolio companies mature and exit through public offerings or acquisitions.

The reduced fee structure of co-investments helps mitigate the initial negative impact of the J-curve, while allowing LPs to participate fully in the eventual upward trajectory of returns. Investors must be aware of hidden fees like administrative fees and fees charged by parties related to the VC manager.

Increased capital deployment and portfolio control

Co-investors leave due diligence and negotiating the deal to the VC manager, while, crucially, they keep the investment decision for themselves, providing them with agency in building a portfolio versus a fund investment approach. In the VC context, this allows LPs to increase their allocation to specific breakthrough technologies or exceptional founding teams that demonstrate the potential for outsized returns.

Portfolio transparency

Direct participation provides LPs with enhanced transparency regarding investment deployment and strategic focus areas, enabling more informed portfolio construction decisions. For VC investing, this transparency is crucial given the binary nature of startup outcomes and the importance of understanding exposure to specific technology trends.

Access to exclusive opportunities

Co-investments frequently provide access to later-stage rounds of the fund's most successful portfolio companies, allowing LPs to participate in the value creation that occurs as startups scale and mature. A classic win-win example is where the main fund is already at its diversification limit with regard to a well-performing company, and the VC manager uses the co-invest route to drive further funding from its LPs into this opportunity.

VC manager and portfolio company benefits

Benefits for VC managers

The benefits of LP co-investing for VC managers are more nuanced. Offering co-invest products allows VC managers to drive more volume, increasing their total assets under management and LP loyalty; however, they can cannibalise demand for the funds they manage in the process. Co-invest products are a much less stable source of revenue and should be used as an addition to a VC manager's primary fund business.

Benefits for portfolio companies

Co-investments offer clear benefits for the fund’s portfolio companies. They offer additional capital but shift the sales workload onto their existing VC fund investors. These VC fund investors can also act as a shield in terms of administration and corporate governance, so the portfolio company keeps its own cap table lean.

Structural arrangements

LPs can access co-investment opportunities through several arrangements including the following basic structures.

Fund-of-one structures

These single investor funds or entities are dedicated vehicles for individual LPs, providing maximum LP control but generally requiring higher minimum commitments to cover higher maintenance costs. In VC co-investing, these structures are particularly valuable for an LP seeking to concentrate capital in specific technology sectors or address any investor-specific concerns such as tax and confidentiality.

The VC manager may find it challenging to manage several fund-of-one structures from an administrative and negotiation point of view. Monitoring several vehicles and negotiating terms for several vehicles with different investors can be time consuming.

Multi-investor co-investment funds

The VC manager may form a pooled vehicle accommodating multiple LPs, offering cost efficiencies while maintaining direct exposure to specific opportunities. The vehicle can be structured as a regulated or unregulated limited liability company or a partnership. For VC co-investments, these vehicles often focus on later-stage growth rounds where larger capital requirements make pooled participation more practical. The disadvantage for some of these vehicles is that co-investors lose the ability to choose the co-investment opportunities in which they would like to participate.

Standing co-investment vehicles

These structures may be pre-negotiated or consist of 'evergreen' co-investment vehicles and offer the co-investors the opportunity to participate in multiple future opportunities. Variations to this structure include 'pledge fund' mechanisms allowing co-investors to opt in or out deal by deal. In the VC context, these vehicles are particularly effective for participating in follow-on rounds across a fund manager's portfolio.

Direct investment

The VC fund manager may allow the co-investors to take direct equity stakes in portfolio companies. There are variations to the structuring including establishing a holding company co-owned by the co-investors and the main fund's LPs.

The direct equity structure can be problematic for the fund manager which would typically prefer to maintain strict control over its stake, including exit, in the portfolio company. This type of structure can also be more time consuming to complete as the co-investors will often take more time to consider their minority position in the portfolio company. The co-investor must be prepared to oversee its direct investment as the VC fund manager will not be controlling the co-investor's equity and any related voting decisions.

The appropriate structure will depend on commercial (including governance), regulatory, tax, compliance, and cost requirements which can all affect a co-investor's return. The structure may also be driven by the LP's negotiating power. Some LPs will require a structure accommodating their requirements for governance rights, while others will prefer a passive co-investment vehicle.

Essential rights and protections in co-investment documents

When negotiating a co-investment, investors seek terms that provide clear protections and align their interests with the VC fund manager. Key rights include the following.

Information rights

Co-investors seek enhanced reporting and information access beyond standard fund reporting, providing greater transparency into portfolio company performance and strategic developments. In VC investing, enhanced information rights are crucial for monitoring the rapid developments and pivot decisions common in early-stage technology companies.

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Underlying investment exit alignment

Co-investors should ensure that they can participate in any disposal by the main fund under equivalent terms. In VC, exit alignment rights are crucial for ensuring the investors can participate in the full value creation cycle, from early-stage investment through to eventual exit via a public offering or acquisition.

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Co-investment vehicle pro-rata rights

Co-investors should also request rights to participate in subsequent funding rounds to maintain ownership percentages. For VC co-investments, these rights are particularly important given the multiple financing rounds typical of startup companies and the potential for dilution.

A co-investor may decide to exit the position before the underlying portfolio company is liquidated. This is normally achieved through the following provisions in the co-investment agreement.

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Secondary sale rights

Enhanced transfer rights will allow co-investors to sell co-investment interests to third parties, facilitating early exits. In the VC context, secondary sale rights provide important liquidity options given the extended holding periods typical of startup investments.

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Distributions in-kind

The right to receive direct distributions of underlying securities under specified circumstances could not be more important. For VC co-investments, distributions in-kind are especially valuable for technology company public offerings, where LPs may wish to maintain exposure to public market appreciation potential.

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Governance and decision-making authority

Co-investment vehicles typically follow governance structures established by the main fund, simplifying decision-making processes whilst ensuring consistency in investment strategy. In the VC context, governance considerations must account for the dynamic nature of startup companies and the need for rapid decision-making.

Depending on the size of their investment and the co-investment structure, co-investors may negotiate the following rights.

Board representation

Larger co-investors may negotiate board seats in portfolio companies, particularly where they bring valuable industry expertise or strategic value. For VC investments, board representation can be particularly valuable given the hands-on nature of VC investing and the importance of strategic guidance for early-stage companies.

Observer rights

For LPs unable to secure board representation, observer rights provide valuable visibility into portfolio company decision-making without fiduciary obligations. In the VC context, observer rights allow LPs to stay informed about rapid developments typical of high-growth technology companies.

Minority protection rights

The largest co-investors will often negotiate comprehensive veto rights over fundamental decisions in the co-investment vehicle deemed critical to protecting their investment, including new securities issuances and amendments to the co-investment vehicle constitutive documents.

The evolution of co-investment as a standalone product

Angel networks and marketplaces for crowdfunding into startups have existed in the MENA region for quite some time. They have primarily focused on small tickets and non-professional investors. In the past few years, there has been a significant surge in family office networks and marketplaces for professional investors.

VC managers have taken note, and some are creating their own co-investment communities and turning this part of their business into a standalone product alongside their main fund business. It is critical for VC managers to obtain legal advice so they don't breach securities offering regulations and to ensure compliance with local regulatory requirements across MENA jurisdictions. Investors should realise that these arrangements attract similar risks as more formal co-investment arrangements.

Critical implementation considerations for VCs

VC managers looking to add LP co-investment opportunities to their funds should consider maintaining focus and efficiency in their operations. Deal-by-deal fundraising requires effort for sales, review, drafting, and negotiation of legal documentation and post-investment administration. The emergence of modern fund and SPV administration automation tools provides a neat solution to tech-savvy and experienced VC managers.

Similar to private equity co-investing, VC co-investment arrangements present inherent conflicts of interest that require careful management. VC managers must establish clear policies governing when co-investment opportunities should be offered to ensure conflicts between the main fund and co-investment vehicles are properly addressed.

Key conflict areas include the following.

Allocation bias

VC managers may disproportionately allocate attractive co-investment opportunities to prospective future fund investors, creating preferential treatment that disadvantages existing LPs through 'sweetheart deals' that compromise fair allocation principles.

Dilution conflicts

When co-investors reduce the ownership stakes of the main fund investors in portfolio companies, tensions can emerge within the fund structure as different investor classes may have competing interests regarding investment sizing, follow-on participation, and exit timing.

Operational priorities

The administrative demands of managing co-investment relationships may divert management attention from core fund responsibilities, potentially compromising the quality of portfolio company support and strategic guidance that benefits all fund investors.

To mitigate these risks, VC managers should implement transparent allocation frameworks, establish clear eligibility criteria for co-investment participation, and maintain robust governance structures that protect the interests of all stakeholders while preserving the operational efficiency of both the main fund and co-investment programmes.

Conclusion

VC managers need to constantly innovate and evolve their business model. They have to prove to their investors that they continue to be an efficient way to allocate capital into the startup world. Success in co-investment participation requires careful attention to structural design, governance arrangements, and operational capabilities. LPs must balance their desire for control and transparency with the practical requirements of efficient deal execution and manager operational flexibility.

As the regional VC market continues to mature, co-investment programmes will likely become increasingly sophisticated, with enhanced rights and protections for LPs balanced against operational efficiency requirements.

For LPs who successfully navigate the complexities of co-investment structuring and execution, these arrangements offer compelling opportunities to enhance returns whilst building deeper relationships with leading managers and the opportunity to gain direct exposure to the MENA region's most promising technology companies and innovative startups.