This article was written by Mark McFarlane and Suzanne Gibson.
Secondaries transactions have grown substantially in recent years. This growth can be attributed to the host of potential commercial and strategic advantages such transactions can have for both general partners (GPs)/managers and investors, as well as a raft of regulatory pressures, including as a result of the Volcker Rule and the BASEL III reforms.
However, with these advantages come unique legal tensions as investors look to sell their fund commitments with relative freedom and GPs/managers seek to minimise their potential liabilities arising from any sale (and in some cases, reap side benefits).
- The global value of secondaries transactions was approximately $38bn in 2016.
- Aggregate capital raised by secondaries funds as at the end of Q3 2016 ($18.5bn) represented an all-time high for that stage of the year for fundraising by secondaries funds.
- GP-led secondaries comprised almost 25% of secondary market volume in 2016.
- Preqin recently reported that as at the end of Q3 2016, private equity fund of funds accounted for a fifth of all secondaries buyers.
What is a funds secondary and how are secondaries structured?
A “secondary” is the sale of interests in a private equity fund after the fund has been raised but before the end of the fund’s term.
The classic secondaries sale structure involves the sale by a fund’s investor (in the case of a private equity fund, limited partner) of interests in the fund. However, the structure of secondaries sales has become increasingly varied and includes:
- Secondary funds: the establishment of fund-of-funds structures which invest in secondaries opportunities.
- Secondary direct: the sale by a fund of a bundle of interests in portfolio companies the fund is already invested in i.e. selling the underlying interests in the fund’s portfolio companies rather than interests in the fund itself. The buyer will either manage the investments itself or arrange for a new investment manager.
- GP/manager-led secondary restructurings: these transactions typically involve the restructuring of an existing fund (generally including the extension of the fund term) and the incorporation of, so that new investors may invest and existing investors have the opportunity to exit, They can also include a stapled element, being both a secondary element – the purchase of existing interests in a fund – and a primary element – a commitment to subscribe for interests in a new fund which is being, or will in the future be, raised.
- Synthetic secondary: this term covers a raft of structures which n give the buyer economic or beneficial ownership in the relevant fund interests without actually transferring legal ownership of those interests.
Issues to consider from the outset
1. Due diligence
Prospective secondaries buyers will need to conduct due diligence on the fund in which the interests are being sold. Key due diligence points for buyers in a secondaries context include:
- any terms of the fund’s documents which limit the buyer’s future activities;
- the transferability of any side letter benefits the selling investor has with the fund’s GP/manager;
- the investment structure of the fund (particularly whether any interests are held in alternative investment vehicles);
- capital call mechanisms and the ability for prior distributions to be clawed back; and
- transfer provisions which give the GP/manager or other existing investors the right to acquire the fund interests being sold on the same terms offered by the prospective buyer.
Confidentiality is a key concern. Selling investors will seek to give prospective buyers the information they need, while GPs/managers will simultaneously seek to maintain the confidentiality of the fund’s confidential information. For these reasons, a confidentiality agreement is customarily executed early in the process.
A secondaries sale confidentiality agreement should also be extended for the GP’s/manager’s benefit, so as to:
- give the GP/manager comfort that the secrecy of the relevant confidential information will be maintained;
- minimise the risk of breaching any applicable confidentiality provisions in the fund’s limited partnership agreement or other constituent documents; and
- enhance the prospects of the GP/manager consenting to the transfer of the interests being sold.
Saying that, GP/manager requirements can differ markedly and some managers are willing to rely on the provisions of the limited partnership agreement or a simple letter agreement rather than requiring a full-blown confidentiality agreement.
3. GP/Manager consent and involvement
Successful secondaries transactions almost always involve the selling investor working closely with the GP/manager to conduct the sales process. This is because under almost all funds’ agreements, the consent of the GP/manager will be required to effect a transfer of interests in the fund.
The GP/manager will usually be entitled to give or refuse consent to transfer fund interests in its discretion and without giving reasons. In deciding whether to give its consent the GP/manager will be working to balance the competing objectives of making secondaries sales possible while, at the same time, not giving transfer consents so freely that interests in the fund effectively become freely tradable securities. In addition, the assistance of the GP/manager will often be required to enable prospective buyers to receive all the due diligence information they need.
A GP/manager who has a facilitative role may try to protect itself from claims in connection with the secondaries sale by way of exculpation provisions and indemnities given by the selling investor and the eventual buyer. A GP/manager will inevitably also look for reimbursement of its expenses in fulfilling such a role. Typically, the selling investor and buying investor will cover an equal share of the GP/manager’s costs.
Many GPs/managers have restrictions on when they will consent to a transfer of interests – e.g. quarterly, bi-annually or annually, and other factors such as the U.S. “publicly traded partnership” rules may play into timing for consent (see “Tax-related transfer restrictions, below”). Sellers should ensure that they clarify these timing requirements with the GP/manager at the outset of any funds secondary transaction.
Important transaction considerations
1. Purchase price
The purchase price for secondaries is typically fixed on a specified date with adjustments for contributions and distributions after that date. The specified date is typically the most recent valuation date of the investments underlying the fund interests being sold, which can be any length of time prior to the completion date for the transaction.
The timing of the specified date for the purchase price and any future anticipated capital contributions or distributions will be important for both the selling investor and the buying investor as it will impact the investment’s money multiple and internal rate of return. For this reason, a buying investor will often prefer to receive a distribution shortly after closing rather than benefit from a reduction in the purchase price. This ensures that the distribution will represent a return on its investment and possibly increase its reported internal rate of return.
2. Segregation of interests
In the case of a number of fund interests being sold together, the sale agreement should contain a mechanism to segregate any interests which the relevant GP/manager will not consent to the transfer of or which are acquired by other existing investors in the relevant fund pursuant to rights of first refusal.
In bundled secondaries transactions, certain “key” fund interests may also be specified in the sale agreement, being interests which must be transferred to the buying investor before it is obliged to close the purchase of any of the fund’s interests. This protects the buying investor from being forced to purchase only the less desirable interests being sold.
3. Excluded Obligations
Under the sale documents, a buying investor will generally agree to assume and perform all unperformed obligations in relation to the interests being acquired. The result is that a buying investor can end up being liable for obligations and liabilities attributable to the selling investor’s period of ownership.
A buying investor will often try and exclude liability for obligations attributable to the selling investor’s period of ownership.
These “excluded obligations” often include:
- breach by the selling investor of any representations or warranties in the original subscription documents;
- payment of taxes or other charges attributable to the selling investor’s period of ownership;
- other events attributable to the selling investor’s acts or omissions prior to the specified date on which the base purchase price is based; and
- an obligation on the selling investor to repay distributions received prior to the specified date on which the base purchase price is based.
4. Future payments in relation to fund interests
A typical protective mechanism for investors is a clawback provision which provides for repayment to investors of amounts made to the GP/manager in certain circumstances - for example, if the order of distributions over the lifetime of the fund would result in carried interest in excess of the agreed percentage. The right to receive any repayments of amounts paid in the period before the secondaries sale can become a negotiation point if both the selling investor and buying investor seek the right to any such repayments.
Fund documents typically also require the repayment by investors of any previous distributions which have been found to be wrongfully made. Repayment of a distribution can also sometimes be required if certain circumstances occur (such as litigation). Obviously, neither the selling investor nor the buying investor will want to be liable to repay any past distribution. The GP/manager may insist that both investors remain liable for repayment of such distributions to ensure that it can recoup them (although buying investors often require these to form part of the “excluded obligations”, discussed above).
The sale documents will include warranties from the selling investor in relation to title and authority to sell the relevant secondaries and no prior breach of the fund’s constituent documents. In relation to the substantive fund interests being sold, there will also be warranties concerning outstanding litigation or claims, and the accuracy of the historical financial information provided to the buying investor.
Buying investors may request a certificate from the GP/manager confirming the capital contributions by, and distributions to, the selling investor during the period it has held the relevant fund interest. GPs/Managers are typically not obliged to provide such certificates and this can therefore become a point of negotiation.
GPs/Managers usually seek indemnification for breaches of the warranties and covenants in the sale documents as well as to protect the GP/manager against liability in connection with future claims related to the secondaries transaction (for example, a claim of misleading due diligence information).
The sale documents will often apportion liability between the buying and selling investors for any such indemnity payment.
Tax-related transfer restrictions
The parties to a secondaries sale will need to ensure that the transfer complies with all applicable tax and regulatory transfer restrictions. These will largely depend on the jurisdiction in which the fund was formed. For example, virtually all limited partnership agreements for U.S. funds contain restrictions on transfer to prevent the fund being treated as a publicly traded partnership for U.S. income tax purposes. There are a number of so-called “safe harbours” which can help a fund avoid such a classification but the issue needs to be considered in each case to ensure that one of these exceptions applies.
Once the sale document has been negotiated between the buying and selling investors, the parties will need to enter into transfer documentation with the GP/manager to transfer the interests in the relevant funds. Although most GPs/managers will have a standard form of transfer document, their willingness to negotiate the terms of such document differ greatly.
Reported by Greenhill, Secondary Market Trends & Outlook, January 2017
Preqin Secondary Market Update, Q3 2016
Reported by Greenhill, Secondary Market Trends & Outlook, January 2017
Preqin Press Release, 2016 sees record Q1-Q3 Private Capital Secondaries Fundraising Total, 6 October 2016