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Hot secondaries market a legal minefield for GPs

A wave of incoming regulations is helping fuel activity in the secondaries market, which for some GPs means big compliance headaches.

The jump in secondary market activity has resulted in a tussle between LPs – many of which are trying to offload their fund commitments to rebalance portfolios and reduce relationships – and GPs that want to minimise the liabilities and headaches surrounding these transactions.

Any foray in the secondary market invariably means a fund takes on an additional layer of legal risks, which will demand attention from both GPs and the investors swapping interests in those funds

For GPs such concerns arise as any foray in the secondary market invariably means a fund takes on an additional layer of legal risks, which will demand attention from both GPs and the investors swapping interests in those funds.

Such risks only become heightened as more and more limited partners look to shuffle their fund commitments. Triago, a placement agent and secondaries advisor, has pegged total deal volume in the rejuvenated secondaries market at around $20 billion in 2010, up substantially from the roughly $7.5 billion recorded in 2009 and $15 billion in 2008. The numbers, however, differ from estimate to estimate and there is no single source of universally accepted closed dealflow data.

Keeping Secrets

Preserving a fund’s confidentiality is one area of concern for GPs, points out Chézard Ameer, a private equity funds partner at law firm Gibson, Dunn & Crutcher. Prospective buyers in the secondary market will want to conduct due diligence on a fund, making it the selling LPs’ prerogative to provide sufficient information to complete the sale. GPs, however, will seek to limit a potential buyer’s access to a fund’s material information.

“In all potential secondary transactions, GPs will control strictly the dissemination of non-public, fund-level information and may not agree to permit disclosure to competitors or other parties that, for one reason or another, they do not want in their funds,” Ameer says.

If a buyer is ultimately identified, attention must be directed to new matters. Bringing a new investor into a fund isn’t a simple swap of duties but involves intricate negotiations around who’s liable for what under myriad circumstances that could surface prior to a fund’s final exit, sources say.

For example, in the event of a clawback, both the departing and incoming LP will have an interest in the reimbursement. Or to reverse the issue, neither party will wish to remain liable for past distributions to investors in the event they need to be repaid, such as when a lawsuit is ruled against a fund.

Qualified Matching Services

Fund managers also need to be aware of too many LPs shopping their holdings. US tax regulations provide that a limited partnership trading more than 2 percent of its capital in a given fiscal year could be interpreted as publicly traded, and subject to corporation tax.

GPs do not want to stand in the way of their LPs' transactions

Steve Bortnick

“GPs do not want to stand in the way of their LPs' transactions,” and thus typically seek an exemption to the rule should the 2 percent ceiling be hit, says Steve Bortnick, a partner in the tax practice group of law firm Pepper Hamilton.

One exemption that allows firms to raise the trading cap is a “qualified matching service”, which allows LPs to trade up to 10 percent of the fund’s capital before losing its pass-through tax treatment. In 2009, Sun Capital Partners implemented a QMS, allowing its LPs to post information online to prospective buyers in the secondary market.

Setting up a QMS is a complicated and technical process, and few private equity funds have opted to pursue the option, according to Bortnick. Instead, firms with LPs active in the secondary market can pursue other safe harbours, he explains. “For example, for funds with less than 100 partners, the number of secondary trades would be irrelevant.”

It’s also far from clear whether the IRS would actually pursue a firm that finds itself over the trading threshold, according to a source in the secondaries market.

“If you go over 2 percent, that doesn’t mean it’s a publicly traded partnership. It means you could be outside the safe harbour,” the source says. The decision to form a QMS generally comes down to the attorneys representing a private equity firm, who decide if the 2 percent should be a hard and fast rule, the source says.

“Some [attorneys] have decided you can go over 2 percent, as long as you have a fact pattern that proves you are not a publicly traded partnership,” the source says. “This hasn’t been a huge issue because [firms’ attorneys] have stayed flexible.”

Market sources have raised the idea this year that some mega-funds may run up against the 2 percent trading threshold because stakes in their funds have been heavily traded. Several US public pensions, including the California Public Employees’ Retirement System, have turned to the secondaries market to sell chunks of their private equity portfolios. The CalPERS’ sale contained a large amount of mega-fund stakes, sources say, and New Jersey’s state pension is preparing to put an offering on the secondaries market that will also contain some mega-fund holdings.

Taxing Concerns

Inadvertently being labelled a publicly traded company is only one tax concern fund managers need to consider when their LPs enter the secondaries market. LPs who sell their fund interests to a pension fund could subject a GP to a number of constraints under US tax rules.

The Employee Retirement Income Security Act of 1974 says that if pension money makes up 25 percent or more of a fund’s interests, the GP becomes subject to burdensome fiduciary responsibilities and strict standards of conduct. GPs must therefore recalculate the percentage of interests held by benefit plan investors anytime a new pension is brought into the fund.

Steve Bortnick

Historically GPs escaped ERISA rules by operating as a Venture Capital Operating Company (VCOC) – which meant at least 50 percent of a fund’s assets were invested in operating companies (or companies which produce goods and services as opposed to holding companies) and that GPs took a hands on role in the running of the company as majority owners. However this escape route is sometimes difficult because funds have to negotiate “their management rights in the portfolio company and may have difficulty with the structure where they need to acquire a minority investment in through a holding company”, says Pepper Hamilton’s Bortnick.

GPs were thus delighted in 2006 when ERISA rules were relaxed to allow more funds to avoid ERISA regulation by excluding government and foreign pension fund investments from counting towards the 25 percent threshold, says Bortnick. However, care will still be needed with some state pensions who’ve requested to be treated as an ERISA fund to gain certain benefits, he warns.

LPs and Secondaries Sales

Complicating matters for GPs is the possibility that LPs will expect similar treatment upon learning one LP has been permitted to sell off their fund interest, says Timothy Spangler, head of Kaye Scholer’s investment funds practice. “GPs don’t want investors rushing for the exit, they need to make secondary transfers possible but not easy.”

GPs need to preserve an image of treating all LPs equally, continues Spangler. “GPs will also typically try to facilitate these transactions to avoid appearing LP unfriendly or in certain cases to help troubled investors avoid default.”

GPs will typically try to facilitate these transactions to avoid appearing LP unfriendly or in certain cases to help troubled investors avoid default

Timothy Spangler

LPs who sell their stakes because they fear defaulting on a capital call should also be seen as an opportunity, says Valérie Handal, a principal at secondaries investor and fund of funds group HarbourVest Partners.

“The loss of one LP having difficulty in meeting payments can mean the gain of a new LP who is more financially secure and possibly a backer of future funds,” she says. The process means GPs will have to carefully assess the creditworthiness of each new investor brought into the fund, she stresses.

State Influence

Other legal concerns for secondary players result from industry-wide regulations on private equity activity.The EU’s recently passed Alternative Investment Fund Managers directive “will inevitably mean that marketing a secondary transaction will be more complex for sellers using intermediaries and looking to market their interests to EU investors”, says Simon Currie, a partner at Covington & Burling, a law firm – who adds the directive is substantially better than originally proposed.

The AIFM introduces new restrictions on the ability of non-EU fund managers or funds to solicit investors across the 27-member bloc. The directive’s language could potentially prohibit intermediaries (such as placement agents or GPs acting on the behalf of a seller) from marketing LPs’ stakes in funds non-compliant with the directive’s stringent requirements, says Currie. Unless the matter is clarified in follow-up rulemaking, this may in certain instances force an intermediary to split the selling LP’s interests between compliant funds held by the LP and non-compliant funds.

However, some new regulations will likely be a boon for private equity secondaries activity for years to come. A blizzard of new regulations designed to prevent a repeat of the global credit collapse will spur some of private equity’s biggest contributors to rethink their holdings in the asset class. In Europe, the Solvency II directive, scheduled to be introduced in November of 2012, will introduce risk-based solvency requirements for insurance and re-insurance groups. It looks likely that the capital a European insurer would need to hold against its private equity assets will increase. Indeed, insurers are likely to “reduce appreciably” their private equity holdings, perhaps even stopping investments in the asset class altogether, according to a study carried out by the EDHEC Financial Analysis and Accounting Research Centre last year.

Likewise, the world’s central banks are currently hammering out details that will introduce higher capital requirements and liquidity measures for banks. As a result, Basel III, scheduled to go into effect between 2015 and 2018, will increase the risk weighting of private equity assets. The move pushes (or at least encourages) banks to pare back their private equity portfolio or to spin-out captive management teams entirely.

US banks will have even less room to manoeuvre in private equity. An element of the Dodd-Frank Act, dubbed the “Volcker Rule”, restricts banks from investing more than 3 percent of their Tier 1 capital in the asset class, and further limits any ownership stake in a fund to 3 percent.

The effect on the secondary market could be extraordinary considering banks historically account for more than one-quarter (26 percent) of private equity deals, according to a study carried out in 2010 by Harvard Business School which tracked private equity transactions between 1983 and 2009.

Should the secondary market kick in to higher gear as expected, fund managers will look on knowing they will have to continue managing the risks that come with it.