The prices of private equity fund interests have been trending upward since the financial crisis, as the valuations of the underlying portfolio companies of these funds have stabilised. This led to record levels of activity in the secondary market in 2010, as measured by dollar amounts invested, and a similarly robust market in the first half of 2011, when there was estimated to have been a record $14 billion of completed deals.
Nonetheless, the current market environment continues to provide attractive opportunities for investors, relative to historical levels. The purchase price for an interest in a private equity fund is generally based on the fund’s net asset value (NAV), which is usually determined by the fund on a quarterly, semi-annual or annual basis, as of the last day of such period. In a secondary market transaction, this is generally referred to as the “cut-off date”, and is normally set by buyers and sellers as the date of the most recent NAV calculation.
At closing, the purchase agreement for a private equity interest normally provides a price adjustment – with a dollar-for-dollar increase in the purchase price for any capital contribution made by the seller after the cut-off date, and a dollar-for-dollar decrease in the price for any distribution received by the seller after the cut-off date.
The purchase price can be either at the NAV, or at a discount or premium to the NAV. Historically, prices have trended close to par, with only a moderate discount or premium – although in the middle of the financial crisis in 2008 and 2009, private equity interests were traded at a steep discount to their NAVs.
GETTING THE CONTRACTS RIGHT
After the initial price negotiation, the buyer and the seller may enter into a non-binding letter of intent or term sheet to memorialise their understanding of the transaction. This would serve as the foundation for the drafting and negotiation of the definitive purchase agreement, which would contain the terms and conditions of the transaction.
If the buyer is buying a portfolio of private equity interests (i.e., interests in multiple funds) from the seller, and the transfers of interests in the various funds are not going to be consummated at the same time, the buyer may require, as a closing condition, the consummation of the transfers of certain “key” funds before the transfers of other funds can be completed. This type of condition would protect the buyer from purchasing only the less desirable fund interests, if the transfers of the more desirable interests end up not being consummated. This may happen for different reasons, including the withholding of consent by the fund’s general partner.
Another important buyer provision is the indemnification of the buyer by the seller if the buyer is required to return any distribution made by the fund in order to satisfy its indemnification obligations – generally referred to as a ‘limited partner giveback’. Almost all limited partnership agreements require limited partner givebacks to the extent that the fund does not have sufficient resources to satisfy its indemnification obligations. The general partner in almost all cases would require the buyer to assume the seller’s giveback obligations. Therefore, a judicious buyer will require the seller to pay for such giveback to the fund, at least to the extent attributable to distributions made to the seller.
Limited partnership agreements normally impose strict confidentiality obligations on private equity investors, which present a challenge to sellers and buyers in the secondary market. Buyers need information about the fund, as well as its portfolio investments, in order to evaluate the investment opportunity accurately. The parties normally address this issue by approaching the general partner early in the process and having the buyer enter into a confidentiality agreement with the general partner. This limits the buyer’s ability to release or use the confidential information it obtained regarding the fund and its underlying investments.
GETTING THE GP ON SIDE
The document for the assignment by the seller and assumption by the buyer of the interest in a private equity fund is a transfer agreement. Because almost all limited partnership agreements provide the general partner with the absolute right to consent to a transfer of an investor’s interest in the fund, the general partner would either be a party to the transfer agreement or would bless the transfer by executing a consent form, which is normally attached to the transfer agreement. Each private equity fund should have a form of transfer agreement that its investors and potential investors must execute for the transfer to take effect.
Most limited partnership agreements also require the seller or the buyer to furnish a legal opinion to the general partner regarding certain securities law, tax law and other regulatory compliance issues: for instance, a general partner will want to ensure that its fund will continue to be taxed as a flow-through entity after the transfer, and that the transfer would not trigger any securities law registration requirement. However, in practice, many general partners would waive the legal opinion requirement and require the buyer to make representations to the same effect in the transfer agreement.
Certain funds also have ‘right of first refusal’ provisions, which require an existing limited partner to offer its interest to the other existing limited partners in the fund and/or the general partner on the same terms as the interest is being offered to the third-party buyer, before the transferring investor can sell the interest to the third-party buyer. The seller must either comply with the offering procedure under the right of first refusal provisions, or obtain the waiver of the other partners in the fund in respect of their right to acquire the seller’s interest. This kind of right of first refusal provision would, of course, delay the sales process.
Limited partnership agreements also normally require the seller and/or the buyer to pay the general partner’s out-of-pocket expenses, including legal fees, in connection with the transfer. For accounting and administrative convenience, general partners normally require transfers to take place at quarter-end. In addition, to the extent that the capital commitments to the fund have been pledged by the fund as security to support its credit facility, the consent of the lender(s) to the fund for the transfer may be required.
More general partners are also requiring joint and several indemnification in the transfer agreement by the buyer and the seller for breaches of representations, warranties and/or covenants by either the buyer or the seller. Buyers and sellers should resist such joint and several indemnification requirements, especially sellers who want to minimise their potential liabilities related to ownership of the fund interest after it is transferred to buyers (or make sure this is addressed in the purchase and sale agreement between buyer and seller). In some cases, the general partner would require the seller to satisfy the buyer’s obligations to the fund to the extent that the buyer fails to satisfy such obligations.
GETTING THE TIMING RIGHT
A seller and a buyer of private equity interests should approach the general partner of the fund early in the process, so that the buyer can perform the necessary diligence on the fund and its portfolio companies without the seller running afoul of its confidentiality obligations under the fund agreement. In light of the current market turmoil, it is generally in the interests of a fund sponsor to permit and facilitate a requested transfer from an existing limited partner to maintain its fund’s limited partner base – as long as the buyer is satisfactory to the fund sponsor.
Given the myriad of legal issues that could be involved in a transfer of private equity interest, all parties to a transfer, including the general partner, should consult with legal counsel early in the process.
Robert Carlson is a partner and Stanley Liu is an associate in the corporate department at international law firm Paul Hastings. Both are based in the Los Angeles office, where they regularly represent sponsors of private equity funds.