The secondary¹ market has experienced rapid growth over the past decade, and that growth has been particularly fast in the last five years. The most striking feature of this growth is the general partner (GP)-led secondary transaction. GP-led transactions comprised 32% of all secondary transactions during 2018, accounting for approximately $24bn in deal value². This represents a 71% increase as compared to 2017. Not only has there been growth in the number and size of GP-led secondary transactions, but there has been exponential growth in the complexity of such transactions. This poses opportunities as well as risks for sponsors and their investors, particularly in the current macro-economic environment and regulatory landscape.

This article draws together a number of trends and developments, and highlights factors that could bring GPs into the crosshairs of regulators reviewing a GP-led secondary deal.

The Evolving Secondary Market

The secondary market is essentially a source of innovation in terms of allowing sponsors and investors to more effectively manage liquidity in what is otherwise an illiquid asset class. Historically centred around private equity, secondary transactions are now also seen involving real estate, infrastructure and credit funds. Long gone are the days when secondary deals involved only plain vanilla LP-led sales of LP interests. Current secondary transactions often involve GP-led: fund restructurings; re-caps; single asset deals; “stapled” transactions³; preferred equity transactions; and restructurings of groups of funds or combining groups of assets in a more cohesive way in order to boost returns. These complicated transactions also require careful consideration of tax issues, as restructurings of portfolio investments or of the funds themselves often involve vehicles – whether the fund vehicle itself or a special purpose vehicle utilised for investment – that were designed to minimise the tax of a certain class of investors but which could create adverse tax issues for a secondaries purchaser with a different tax status.

These aspects bring a new level of complexity that requires specialist skills to navigate.

Confluence of Risk-Related Factors

This article identifies a number of factors the authors have observed that, in turn, may cause greater regulatory scrutiny of GP-led secondary transactions if the risks posed by these factors are not properly managed.

• Availability of cheap leverage: In some of the most complex secondary transactions, there can be four, five or even more layers of leverage. For example, a portfolio company may be owned by a buy-out fund using leverage and that buy-out fund may utilise a capital call facility. A secondaries fund acquiring an LP interest in that buy-out fund may also use transaction-specific leverage, and all of this may be topped off by a capital call facility at the level of the secondaries fund. This presents a very complex picture of intertwined leverage lines that have not been tested in a market downturn scenario.
• Complexity of transactions: As GP-led secondary deals become ever more complex (we are now entering the so-called “GP-led Secondaries ‘v3.0’” world), there are significant risks for a GP structuring a secondary transaction without the requisite skills. The same is true for buyers. Generally, one cannot approach a GP-led secondary deal with the same investment approach as one would use for a plain vanilla LP-led transaction with relatively straightforward purchase and sale documents. Specialist skills and resources are a necessity, as v3.0 transactions typically combine parts of a fund launch, a restructuring of portfolios or portfolio companies, leverage, M&A and even capital markets deals.
• Conflicts of interest: Although the primary conflict would seem to be between a sponsor and its investors, GP-led secondaries may be more conflict prone than other transactions stemming from their complexity. Other parties come into play, which may create potential conflicts involving: LPs versus LPs (e.g., some LPs want to stay invested as they believe the underlying portfolio has unlocked value, whereas other LPs want to exit, perhaps to replenish their capital so as to make fresh commitments to other funds and strategies); LPs in successor funds, in the event that secondaries purchasers are required to make a “stapled” commitment to such a fund; LPs versus co-investors and portfolio company management teams; and lenders to portfolio companies as well as to the secondaries fund and to the transaction itself. All stakeholders need to buy in to some aspect of the transaction to make it work as a whole, and this requires a great deal of thought, planning and execution skills.

When Things Go Wrong

The complexity and sheer number of moving parts in a GP-led secondary transaction leaves plenty of scope for something to go wrong. From a regulator’s perspective, the following actions by a sponsor are of particular interest:

• Lack of understanding by a sponsor that GP-led secondaries are inherently conflicted transactions. Accordingly, GPs should adopt a “regulator’s perspective” when devising their transaction terms, in areas such as: (i) the fullness and fairness of information they provide to their LPs; (ii) disclosure not only of potential and actual conflicts, but also the steps taken or to be taken to minimise those conflicts; (iii) disclosure of material interests the GP has in the proposed transaction; (iv) whether any LP or group of LPs will be given favourable treatment; and (v) the fairness of the valuation placed on the transaction assets. It is now common for the GP to provide a selling or explanatory memorandum to the LPs, which is similar in detail to an offering memorandum in a primary fundraising (including extensive disclosures with regard to potential conflicts and risks of the transaction).
• Failure by a sponsor to discharge its fiduciary duties. GPs should remember that they are fiduciaries and owe a duty of care to all their investors, as well as being subject to securities laws and regulations (e.g., insider dealing and anti-fraud rules). There also may be contractual requirements in the fund documents pertaining to related-party transactions, which the GP will need to navigate.
• Overly-aggressive sponsor demands on its LPs. GPs should remember that not all LPs possess the same level of sophistication and resources with which to meaningfully assess a complex secondary transaction. If LPs are to make an informed decision as to the direction they wish to take, GPs should not impose tight deadlines by which LPs must make elections (e.g., to choose between the status quo, rollover on new terms or exit for cash). GPs also usually want to be viewed as investor-friendly for future fundraisings.

The Institutional Limited Partners Association, an industry body, published guidelines in late 2018 regarding GP-led secondaries. Although these guidelines do not have the effect of law, they nevertheless seek to establish industry best practice, and LPs (particularly those serving on the Limited Partner Advisory Committee or other similar governing body made up of investors) may find them useful as a form of roadmap to follow when presented with a GP-led secondary transaction. The current approach is consultative, with key LPs being asked for their opinions very early on in the process. In fact, on occasion, GPs have offered the LP Advisory Committee an opportunity to appoint their own counsel to review deal documentation.

What Do Regulators Look At?

At present, there is no uniform approach or practice by regulators around the world regarding GP-led secondary transactions.

The View from the United States

Beginning in 2015, the Securities and Exchange Commission has shown a greater interest in GP-led secondaries, and has sanctioned at least three sponsors over failures to adequately address conflicts of interest. The SEC has focused particularly on allegations that GPs have knowingly undervalued fund NAVs, thereby giving the illusion of a better offer for the LP interest.

In addition to failure to manage conflicts adequately, areas likely to fall under the SEC spotlight include GPs that: (i) continue to manage funds without complying with investor consent and notice obligations in fund documents (e.g., seeking investor consent for an extension to the fund’s life); (ii) continue to earn fees on “zombie” funds where there is little prospect of enhancing returns to investors; or (iii) furnish information to investors that is incomplete or inaccurate (e.g., in a tender offer solicitation).

The View from Europe

There currently is no clear regulatory guidance or discernible pattern of action by European regulators. The European regulatory landscape is quite fragmented. However, LPs as well as buyers in Europe have voiced concerns about GPs following a fair and transparent approach and European regulators taking an invasive stance on the industry.

Although not as large as the U.S. GP-led secondary market, the European market is growing rapidly. In recent years, the UK, Germany, France and the Nordic countries have seen significant year-on-year growth in GP-led secondary deals.

In France, there appears to be a heightened level of scrutiny by the French regulator, the Authorité des Marchés Financiers, on secondary transactions – in particular, on the issue of conflicts of interest.

The View from Asia

There have been far fewer fund restructurings in the Asian market than in other developed markets, reflecting the relatively smaller number of Asian funds that have reached a level of maturity which would make them ripe for a GP-led restructuring. As such, it is not apparent that regulators in Asia have been proactively monitoring the space. Indeed, in Hong Kong, many private equity managers are not registered with the Securities and Futures Commission, which has only recently focused its attention on the licensing of private equity GPs. Accordingly, any of the more-mature funds that may have been restructured are likely to fall outside of the Asian regulatory ambit.

Navigating this Uneven Regulatory Landscape

Thus far, the authors are not aware of any regulator or governmental agency prospectively expressing a view on how GP-led secondary deals should be conducted, or any coordinated effort by regulators around the world to set standards of conduct for GPs wishing to put forward a secondary deal to their LPs.

In the light of this, it would benefit GPs considering a secondary transaction to adopt industry best practices, including the involvement of independent third parties (e.g., valuation agents and transaction advisors) with skill and expertise in this area, while monitoring – through their in-house legal or external counsel – developments in the markets in which they operate (e.g., announcements, news alerts, notices of enforcement actions, and publication of policy statements, rules and guidance by regulators).

It arguably would increase a GP’s chances of mounting a credible defence in a regulatory investigation if the GP can show that it: took reasonable steps to value assets and communicate fairly and in a timely manner with its investors; followed proper procedures; employed an independent valuer; and documented transactions in a fair, complete, accurate and transparent manner, all the while having regard to its fiduciary duties.

Footnotes

1) A “secondary” interest is an interest in an existing fund, parallel fund or co-investment vehicle and/or an existing interest in a portfolio company or asset held by a fund, which is sold by the original investor to one or more existing investors or to a third-party investor – hence, the term “secondary transaction”. This is distinct from a “primary” interest, which refers to an investment in a fund at the time of that fund’s launch.

Note that, in the market, the terms “secondary”, “secondaries”, “secondary transactions/deals” and “secondaries transactions/deals” are used interchangeably. This article generally refers to “secondary” when used with another term and “secondaries” as a stand-alone term.

2) Global Secondary Market Trends & Outlook, Greenhill & Co. LLC, January 2019. The balance of the secondary market is made up of transactions initiated by investors themselves (LP-led secondaries) or by third-party sponsors.

3) A “stapled transaction” is a transaction whereby an investor is permitted to participate in a secondary transaction or fund, provided that it also invests in a new primary fund that is being raised by the same GP or sponsor.