How to manage a sidecar investment vehicle

Understand what a sidecar investment vehicle is, how to use one to pursue high-conviction deals, and what it takes to manage its lifecycle, economics, and compliance.

What is a sidecar investment vehicle?

A sidecar investment vehicle is a specialized fund structure that allows a fund’s existing investors to participate in a specific investment deal alongside the main fund. This structure is typically a special purpose vehicle (SPV) that is managed by the fund's general partner (GP). The GP uses the sidecar to pool capital from their limited partners (LP) for a single, targeted investment.

Think of it like a motorcycle with a sidecar attached. The GP is the driver, navigating the investment landscape based on the expertise required to manage a private equity (PE) fund successfully. The LPs in the main fund are passengers on the motorcycle, and the sidecar offers a select group of those LPs a chance to ride alongside the GP for a specific, targeted journey—a single investment opportunity.

The GP first identifies a compelling deal—often formalizing the valuation, due diligence, and rationale in an investment memo—and then creates the sidecar to gather the necessary capital to fund it. This allows the GP to make a larger investment in the target company than they could with the main fund alone. At the same time, it gives interested LPs more exposure to a deal that the GP has high conviction in.

How sidecars differ from funds and SPVs

While a sidecar is a type of SPV, its purpose and investor base make it distinct. To fully grasp the concept, it's helpful to see how a sidecar compares to other common investment structures. The key distinction is the sidecar's direct relationship with a main fund and its existing LPs.

Why GPs use sidecar vehicles

GPs use sidecar vehicles for several strategic purposes, such as exceeding fund concentration limits or making off-thesis investments. One of the most common drivers is the need to execute follow-on investments to support existing portfolio companies.

GPs typically use sidecar vehicles in a few common scenarios:

• To exceed concentration limits: The governing fund documents, like the limited partnership agreement, often include rules that restrict how much capital can be put into a single company.

• To make off-thesis investments: Sometimes a GP finds a compelling sidecar opportunity, like an early-stage company, that falls outside of the fund’s investment thesis.

• To execute follow-on investments: When a fund is near the end of its life or has deployed most of its capital, it may lack the reserves, or dry powder, for these follow-on rounds.

Common sidecar structures: Overage, annex, and top-up funds

Here are a few common types of sidecar funds:

• Overage funds: Used to invest the amount of a deal that is "over" the main fund's concentration limit.

• Annex funds: Raised after the main fund's official investment period has ended.

• Top-up funds: Raised during the main fund's investment period to take advantage of new market opportunities.

How to manage the sidecar vehicle lifecycle

The lifecycle of a sidecar can be broken down into three main stages:

Step 1: Forming the legal entity

The first step in the SPV formation process for a sidecar is creating a new legal entity. This is typically a Delaware LLC or limited partnership.

Step 2: Onboarding investors and closing capital

Once the entity is formed, the next operational challenge is bringing LPs into the sidecar and collecting their capital commitments through a capital call.

Step 3: Administering the investment and reporting to LPs

After the investment is made, the ongoing management responsibilities begin, including tracking the investment fund performance, preparing quarterly financial reports, and managing communications with LPs.

How are sidecar economics structured?

Sidecar investments typically offer more favorable terms, as it's common for GPs to reduce or even waive management fees and carried interest.

• Management fees: LPs pay the GP to cover the fund's operational costs.
• Carried interest: The GP's share of the profits from an investment.

How to manage conflicts and compliance

For any fund CFO, GP, or those making investment decisions, upholding your fiduciary duty and managing risk are paramount.

The “cherry-picking” risk and regulatory exemptions

To prevent unfairness, the Investment Company Act of 1940 generally prohibits affiliated funds from engaging in joint transactions.

Best practices for fairness

• Offer opportunities on a pro-rata basis: Ensure fairness as opportunities are typically offered to existing LPs on a pro rata basis.
• Maintain clear allocation policies: Written policies prevent accusations of cherry-picking the best deals.
• Disclose all terms transparently: Ensure all parties involved know exactly what they are agreeing to.

Integrating sidecars into your fund strategy

Sidecars are a strategic component of a modern fund manager's approach to agile capital deployment. By using sidecars, you can seize unique opportunities and enhance LP relations.

Frequently asked questions about sidecar investments

What is the difference between a sidecar and co-investment?

A sidecar is structured and managed by the GP for the fund's LPs, while co-investment is a broader term that can refer to an LP investing directly in a company alongside the fund.

What are the tax implications of a sidecar investment?

When structured as a pass-through entity like an LLC or LP, the sidecar itself is not taxed. Investors are responsible for reporting their share of any income or gains on their personal tax returns.

Can a sidecar vehicle invest in more than one company?

While most sidecars are created for a single deal, structures like overage or top-up funds can be designed to invest in multiple opportunities.