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.

A main fund is designed to invest in a portfolio of multiple companies, spreading risk across different assets within their investment portfolios according to a broad investment thesis developed during portfolio construction. In contrast, a standard SPV is a standalone vehicle that can be used by any group of accredited investors, like an angel syndicate, to invest in a single company, and it doesn't require a preexisting main fund.

A sidecar vehicle sits between these two. It is also a single-asset vehicle, but sidecar investors are primarily the existing LPs from the GP's main fund, creating a focused opportunity for a group that already has a relationship with the fund manager.

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 p ortfolio companies.

As the venture capital market has shifted, the need for this kind of bridge financing has become more frequent, partly because the average holding period for portfolio companies has increased, requiring more capital over a longer duration. 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 that falls outside of the fund’s investment thesis.
• To execute follow-on investments: A sidecar allows LPs who are excited about a company's progress to double down on a winner and provide the needed startup funding for its next stage of growth.

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

Sidecars can be structured in several ways depending on their specific purpose. 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 to provide follow-on capital.
• 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 administrative process for managing an SPV has historically been complex and manual. The lifecycle of a sidecar can be broken down into three main stages:

Step 1: Forming the legal entity

Creating a new legal entity, usually a Delaware LLC or limited partnership. This process involves drafting operating agreements, managing state filings, and obtaining a federal tax ID number.

Step 2: Onboarding investors and closing capital

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, ongoing management responsibilities include tracking the investment fund performance and preparing quarterly financial reports.

How are sidecar economics structured?

Sidecar investments typically offer more favorable terms, which is a key reason why LPs find them attractive. Sidecar vehicles usually waive or reduce management fees and carried interest.

How to manage conflicts and compliance

Managing conflicts of interest with sidecar arrangements is crucial. Best practices include:

• Offer opportunities on a pro-rata basis: Ensuring fairness as opportunities are typically offered to existing LPs.
• Maintain clear allocation policies: Outlining the rules for deciding which deals go into which vehicle.
• Disclose all terms transparently: Ensuring all parties involved understand what they are agreeing to.

Integrating sidecars into your fund strategy

Sidecars are more than just one-off fixes for portfolio constraints; they can become a core part of your firm's investment strategy. Integrating sidecars and other SPVs can facilitate bespoke investments.

Frequently asked questions about sidecar investments

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

A sidecar is a specific type of co-investment vehicle.

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 receive a Schedule K-1 and are responsible for reporting their income.

Can a sidecar vehicle invest in more than one company?

Some structures like overage or top-up funds can be blind-pool vehicles, designed to invest in multiple opportunities.