Secondaries

Explanation

In most cases, fund interests are illiquid investments (unless, as is sometimes the case, the fund is established as a publicly traded company). It is likely that some LPs at some point during the life of the fund may wish to or need to seek to sell their participation in the fund. This can arise for a variety of reasons and need not have anything to do with the performance of the fund. The selling LP or transferor will normally approach the GP, whose consent is usually required to complete the transfer. The GP (and remaining LPs) will be concerned in particular to ensure confidentiality provisions are observed in any such transfer to protect the interests of the fund and its portfolio companies. Accordingly, the GP would normally agree with the transferor a list of potential transferees who may be approached (which would typically include existing LPs) and ensure appropriate confidentiality undertakings are obtained from those being approached.

Where the fund is not traded, typically a privately negotiated secondary sale contract will be formed between transferor and transferee. Rights and obligations under the fund documents must be properly transferred to the buyer, so that the fund may continue to function with the replacement investor in place; hence the need to obtain the GP’s consent to any transfer.

The GP will also need to ensure the transfer is handled properly in accordance with both the procedures and requirements set out in the fund documentation and general law (including rights of first refusal, if any, and anti-money laundering requirements). The LP buying the participation will need to satisfy all of the requirements relating to a participation in the fund.

In funds with a high number of LPs, the GP may also need to be mindful of the obligations under general law. For example, the GP may need to limit the number of secondary transactions which may take place in any one year in order to retain the fund’s status as exempt from public offering requirements.

Recommendation

It is standard for any LP transfer to be subject to the GP’s consent. In order to ensure that such consent is forthcoming, when an LP is seriously considering selling its participation, it should contact the GP at the earliest opportunity and the GP should confirm the confidentiality and other procedures to be complied with and documentation to be completed before any transfer can be finalised.

The GP and LP (or its advisers) should discuss what information about the fund and its investments can be shared with whom and at what point in the process of executing the secondary sale. Disclosure should, in accordance with industry practice and protocol, ideally be timed to take account of the fund’s financial, investment and general reporting cycle. This helps to minimise disruption to the fund’s operations, and also expenses incurred in connection with the transfer, as well as to ensure fairness to all stakeholders.

On the transfer of any asset, professional advice should be sought to make sure that no existing rights are contravened and all obligations are properly transferred.

Normally, costs related to an LP transfer should be borne by the transferor, transferee or both, rather than the fund.

Explanation

With the development of an increasingly sophisticated private equity secondary market and an increased focus on providing liquidity, more complex solutions are available to provide liquidity for LPs. Particularly towards the end of a fund’s term, or if a GP undergoes disruptive change, GPs and/or LPs may seek to accelerate the realisation phase, through a purchase of all or a substantial portion of the fund’s remaining portfolio in a single transaction, a “secondary direct.”

Such purchases may also involve the GP remaining involved in the ongoing management of the assets, which raises a potential conflict with its existing LPs. In some cases, some LPs may also be offered the opportunity to re-invest in the assets, raising conflict issues relative to those that choose not to participate in the transaction.

If the fund documents and conflict resolution procedures require decisions to be made by the LPAC, the role and interests of the LPAC members as a group and of the LPAC members individually may impact on how such decisions are framed, documented and approved. Fund documents may also require direct LP votes, or the development of specific transaction mechanisms for LPs to elect whether to realise or to continue investing in the assets. Certain LPs may be affected by conflicts of interest that do not apply to the LP body as a whole.

While selling assets one by one allows the GP to focus solely on realising its return objectives for the portfolio company, in a secondary direct sale of a number of assets there is greater potential for conflicts and heightened scrutiny of the decision-making process should be expected.

Recommendation

A secondary direct sale of a number of assets together will require detailed planning to ensure that all conflicts are properly identified and dealt with. The GP should carefully assess, process and document the potential conflicts and ensure these are fully addressed, as set out in this Handbook, subject to applicable law and the fund documents.

Throughout the process, the GP should remain prepared for developments which may require adaptations of the original plan.