The top challenges of the private equity business model have always been threefold: replenishing the coffers every four to five years, deploying capital successfully in the investment period and harvesting investments at the peak of their valuations. Underlying these concerns is one salient fact: the fund usually has a finite term. Since nothing goes perfectly in life or investment management, this article considers the challenges faced by fund managers as the fund approaches the end of its term.
Though a GP may plan to exit each portfolio company before the end of the original term, some portfolio companies may not be ready to be sold before that date. Opinions differ on what will be left: winners or non-winners.
Non-winners might mean an investment where there is still work to be done (the investment may have been partially written down or not), or it could refer to write-offs. If the GP is still working with the portfolio companies at the end of the initial term, it is because the investment thesis took longer to implement and there is an expectation of value creation to come. In the write-off case, the GP may need to take various actions to dispose of entities, the costs of which may increase its loss.
The chassis that underlies all options for managing the tail end of a fund’s life is the fund’s governing agreement – the limited partnership agreement. A host of terms found in an LPA are the end of life tools available to GPs and offer certain options and leverage to the investors.
While some funds are starting to use longer, or even perpetual, terms, most PE model funds have a 10-12 year term, which can be extended once or twice (or, on rare occasions, three times) for periods of one or, less commonly, two years each.
In the current environment, extensions are one of the LPA terms most heavily negotiated by LPs. They know that the time to control the end of the fund’s life is at the formation stage. While GPs want to control the lifespan, they are rarely able to extend more than once by themselves. A second extension will likely require approval from the Limited Partner Advisory Committee or a majority of the LPs. If the LPA allows three extensions of one year each, the first would likely be controlled by the GP, the second by both the GP and the LPAC, and the third by the GP and a majority of the LPs.
Explicit provision for an extension with consent from a majority of the LPs is not necessary if the LPA can be amended with LP majority approval; so an LP-approved extension, if included, would require something more than the percentage required to amend the LPA.
WHY THE LPA MATTERS
In addition to extensions, the terms that may dictate what happens at the end of the fund’s life are laid out in the agreement. Such terms include:
— The LP’s ability to dissolve the fund
— The ability to clawback distributions from LPs to pay fund expenses
— Side letters concerning secondary sales
— Allowances for distributions of securities
— Limitations of a GP’s fiduciary duties
While the extension is covered explicitly in the LPA, the economic issues surrounding extending a fund’s life – management fees, for example – tend to be left to be negotiated at the time of the extension. If there is nothing in the LPA about management fees during an extension period, then fees will still be payable. To avoid fees, there would need to be an affirmative statement that no management fees would be paid if the fund is extended. If such an affirmation statement is included, but the extension is allowed with LPAC approval, then the committee may, if expressly authorised in the LPA, nonetheless agree to pay a management fee at the same or a reduced level when consenting to the extension. Of course, the LPAC can always ask the GP to obtain LP approval to provide for a management fee for an extension period.
Carried interest is usually unaffected by an extension, but LPs or the LPAC may negotiate for no carry growth in an extension, while retaining that losses will reduce carry until the fund dissolves. Careful attention needs to be paid to what GP behaviours are incentivised during the extension period.
Other typical LPA terms that impact what can happen at the end of the fund’s life are:
- The LP’s ability, with a high percentage approval (often 80-85 percent), to dissolve the fund. It should be explicit in the LPA as to whether a vote to dissolve can be followed by a vote to reconstitute (or continue) the fund with a different GP.
- The ability to clawback distributions from LPs to pay fund expenses that are not covered by portfolio proceeds or capital calls. These are often limited by amount (25-35 percent of commitments) and time (no clawback of distributions made more than two to three years prior).
- Allowance for distributions-in-kind of marketable and/or nonmarketable securities, together with elections available to LPs to cause the would-be in-kind distribution to be held and sold by the GP/fund, and the GP’s responsibilities to deal with such securities on behalf of an electing LP.
- Side letters whereby GPs may promise to assist in the secondary sale of the LP’s interest in the fund if the LP requests it.
- Limitations that restrict the GP’s fiduciary duties to the “duty to act in good faith.”
This reduces potential GP liability to investors and reduces the potential need for fund indemnification payments to the GP. Such relief changes the way GPs may think about their responsibilities.
There is one fundamental question that changes how GPs think about extensions and the provisions at the end of the fund’s life: Is the management team raising a new fund? If yes, there are fewer revenue pressures on the GP. If no, it is a different dynamic. Mostly this will impact the economics negotiated for extension periods. But it also relates to the psyche of the managers.
For a GP to meet its fiduciary duty (whether limited to good faith or not), it needs to avoid a fire sale. Fire sales benefit no one, but forcing them can be on investors’ or managers’ agendas in exerting leverage on other points. In seeking an extension to avoid a fire sale, whether approved by the LPAC or structured as an amendment approved by LPs, the GP must articulate the expected trajectory of the companies that remain in the portfolio if X, Y or Z happen.
When the fund has written-off an investment, there could be a holding company or blocker structure owned by the fund that needs to be dissolved. If the portfolio company is in Chapter 7 liquidation, there is not much the fund must do; if it is being sold in Chapter 11, the fund may need to take actions as a shareholder. If a fund manager still sits on the company’s board, there are special considerations for which the fund will seek legal advice. This is the most unpleasant of wind-down situations: all cost and no upside. While these expenses are generally fund expenses, that is little solace.
Distributions of marketable securities
LPAs generally allow distributions of marketable securities at any time. In the US, “marketable securities” generally means that the securities were acquired in a private offering and are “restricted securities”, but that a public market in the same class as the securities held (or a class into which the securities held are convertible) has developed, and the “restricted securities” may be sold into the public market under Rule 144 (free of volume limitations) or pursuant to a registration statement. Even if the securities held by the fund are marketable, many investors are not equipped to hold and/or sell them in their own names and want the GP to hold and sell on their behalf.
For investors to sell marketable securities distributed to them in kind without Rule 144’s volume limitations, the securities must have been issued to the fund more than six months (or a year in some circumstances) before the distribution; the distribution must be done pro rata (ie, in accordance with the waterfall); and the distributee (as well as his or her family members) cannot be an affiliate of the issuer at anytime in the prior three months. A member of the fund’s management team often has a board seat on the portfolio company being distributed, making that individual (and each of his family members) an affiliate. Each member of the fund’s management team (and their families) is an affiliate for as long as the fund owns 10 percent of the issuer.
Distributions in kind generally involve the GP establishing (or receiving from LPs) brokerage accounts in the name of the non-affiliate LP recipients to which the marketable securities are distributed. With the requisite Rule 144 legal opinions, these accounts can receive the marketable securities free of restrictive stock legends and can be freely tradable.
If LPs cannot or will not deal with receiving marketable securities, the GP generally establishes a brokerage account in its name for the LP’s benefit. Careful attention is needed to ensure the GP does not bear the taxable income associated with selling or holding the securities (the account should use the tax identification number of the LP electing to have it so held, and, in effect, be a trust for the benefit of the LP), and that holding it in the GP’s name does not make the account an affiliate of the issuer.
For this and for liability mitigation reasons, the GP should ensure that it is just an administrator of the account and will act with respect to the securities only at the LP’s direction, and that all risk of loss is for the LP’s account. In return, the GP generally earns no management fee for the account and has no share of any further appreciation in the securities deposited in the account.
Secondary sales of LPs’ interest in the fund as it nears the end of its life are growing increasingly common, enabling those who do not want to stay invested to exit. GPs and LPs usually begin looking at this option when there are two or three years left in the fund’s term (including extensions).
Secondary sales can be brokered by GPs (usually for no compensation, to avoid broker-dealer issues), or initiated by an LP or a group of LPs, or a third party. If initiated by a third party, tender offer rules may apply, adding complexity to the transaction. If the third party is initiating the purchase at the same time as it or its affiliate is making an investment in the next fund being formed, ie, a stapled secondary, great care is needed to ensure that all material factors influencing the purchaser, the GP and the principals, and the buyers, are disclosed to the LPs being asked to sell.
A frequent question is whether the purchaser can pay more to recalcitrant LPs to bring them into the seller group. The answer generally is “no”, but it is a facts-and-circumstances legal analysis.
Distribution of non-marketable securities
Distributing non-marketable securities, which is generally only allowed at the end of the fund’s life, is a different issue. LPs usually cannot tell the GP to hold the securities on their behalf. So what happens to securities that cannot be sold before the fund is dissolved? Here are a few options:
- Sell at any price. Likely buyers may be the issuer or other shareholders of the issuer. Third parties could be a buyer, but the time pressures to sell will be well known and will depress the price offered. A low price means the third-party buyer may not get much due-diligence cooperation from the portfolio company, putting additional downward pressure on price. If the fund has a control position, careful attention is needed regarding fiduciary and other responsibilities the fund has to the issuer’s minority shareholders. For this option to be viable, it is best if the LPA expressly allows the GP to sell, regardless of price, at dissolution. There may still be restrictions in the issuer’s shareholders’ agreement or operating agreement that prevent unilateral action by the fund.
- Transfer to a liquidating trust. A liquidating trust is a “fictional account” – not an entity – which requires formal documentation and a person (or entity) to act as trustee. Careful attention is needed to not increase the GP’s fiduciary responsibilities with respect to the securities transferred into the liquidating trust. Most LPAs contain provisions that the GP will serve as trustee of the liquidating trust and/or for a majority of the LPs to appoint another trustee if the GP has been removed or is unwilling to serve. LPs may also use the LP-driven dissolution provision to dissolve the partnership and reconstitute it as a partnership with a different GP in order to do essentially the same thing.
- Transfer a remaining portfolio security to a subsidiary investment entity of the fund, and distribute the equity interests in that entity to the LPs. This essentially converts the final portfolio investments into separate special purpose vehicles. The end result is the LPs own one or more entities, each of which is managed by the fund manager and owns a single investment. They could own it indefinitely unless the SPV agreement provides otherwise. The economics to the GP are best negotiated with LPs at the same time and in the same manner as an amendment (unless the LPA contemplated it). There are many options for the terms of the SPV, but GPs must be certain they do not engage in a “principal transaction” under Section 206(3) of the Investment Advisers Act of 1940 unless they have the applicable consent.
- Have the GP purchase at an appraised FMV. This is a classic principal transaction under Section 206(3).
Section 206(3) transactions
Section 206(3) of the Investment Advisers Act of 1940 prohibits the GP or any fund manager from engaging in or effecting a transaction for the fund while acting either as principal for its own account, or as broker for a person other than the fund, without (i) disclosing the principal’s role in the transaction in advance and in writing to the “client” and (ii) obtaining the “client’s” consent.
If the LPAC may approve Section 206(3) transactions, it is wise to include in the fund’s offering documents that the LPs explicitly empower the GP to form a committee of representatives of LPs (or their advisers) who are not affiliated with or related to the GP to act on behalf of all LPs in considering and approving transactions for which investor consent is necessary pursuant to Section 206(3).
Although the term “client” in many contexts of the Advisers Act means the fund itself, for Section 206(3), it means the LPs. Clear disclosure is needed that the LPAC can grant this consent on the LPs’ behalf. The disclosure should include full descriptions of conflicts that exist or might arise. Such a conflict exists, eg, if LPAC members (or their affiliates) are invested in other vehicles that may be enhanced by the transaction.
Negotiations with LPs or LPACs at the end of a fund’s life are complicated. There can be multiple agendas inside and outside the fund, its LPs and management team. LPs and managers must remember that, regardless of whether the LPA waives fiduciary duties, the goal is still maximising the value of the remaining portfolio. Planning early, and making decisions with transparency and without pushing the margins, helps ensure a smooth transition.
Julie Corelli focuses on the design and counselling of investment partnerships of all types, covering formation, regulation and deployment of capital. Her client base includes funds, family offices, strategic investors and operating companies.
This article was sponsored by Pepper Hamilton and first appeared in the Legal Special which accompanied the April edition of Private Equity International.