The Institutional Limited Partners Association is calling for continuation fund processes to be more deliberative and transparent in a new guidance document that it compiled partly to address “growing LP frustrations” over how the GP-led secondaries deals are handled.
The trade group criticised the handling of the recently popular transaction type for two reasons. It said that LPs are being rushed into deciding whether to sell or roll their investments into the funds, with as little as 10 days given. Such a short schedule is challenging for LPs facing re-underwriting, ILPA said, which means they’re forced to cash out “if the timeline doesn’t align with institutional requirements, such as investment committee meetings”.
The organisation also said that GPs have conflicts of interest because they are involved in both the buying and selling sides of the funds’ deals, spurring it to push for more disclosure.
Being timely and meticulous
The guidance, which is for both LPs and GPs to use, said that LPs should get at least 30 calendar days or 20 business days to decide on whether to sell or roll investments. It also calls for GPs to meet with LPACs to review proposed deals 10 business days before the election periods begin.
ILPA cautioned that some LPs need ample time due to internal requirements. It noted that this is because they must conduct due diligence steps from scratch, since continuation fund transactions count as new investments. The steps can include re-underwriting and getting approvals from investment committees.
LPs have previously expressed frustration to Private Equity International about the short amount of time by which they typically must respond to a GP running a continuation fund process.
“When that email pops into your inbox, it’s the last thing you want to see,” the former head of private equity at a major US public pension told PEI last year. “The default option is often an automatic sell, which seems like a pretty short fuse to me.”
Speaking to PEI last year, Skandia Asset Management’s head of private equity and infrastructure said the Swedish insurance unit would be supportive of GP-led secondaries processes that involve well-performing managers who have a valid reason for wanting to conduct such transactions, provided there is a good roll alternative, a good sell alternative and the price is seen as fair.
“If it’s properly done so that it really is about riding that winner [for] four or five more years, then I’m in favour of that,” Daniel Winther said. “[But] we’ve seen situations where the price is obviously not fair, where they could have sold an asset for a higher price, but they decided to roll into a continuation fund at a lower price,” he said, adding that Skandia has mostly sold in continuation fund processes.
ILPA’s latest guidance notes that LPs that don’t give answers during their election windows should be given liquidity by default, stating they “should never be forced to roll their interests into a new vehicle”.
The group said that GPs should reach out to their funds’ LPACs to discuss their proposed continuation fund deals as early as possible.
The guidance suggests that GPs should proactively engage in informal talks with the committee and formally present their rationales for transactions to LPs, including why they want to go with continuation fund instead of alternatives such as traditional exits or fund extensions. It added that GPs’ rationales should cover capital needed, affected portfolio companies’ quality, anticipated time to future realisations and exit plans.
ILPA urged LPs to pay close attention to continuation fund deals affecting less mature funds.
“The rationale should be heavily scrutinised in circumstances where the existing fund has remaining unfunded capital or is within the first five years of the inception of a fund,” said the group, which counts almost 600 members with over $2 trillion in private equity assets under management.
LPs’ side letter terms should be carried over to either the continuation fund’s LPAs or to new side letters, the group said. It added that side letter terms that aren’t applicable “may be negotiated as they occur”.
The guidance also calls for disclosure of fund terms for new LPs that are joining the funds, along with explanations for why the terms may differ from those that rolling LPs currently have.
Handling conflicts and fees
ILPA endorses obtaining outside fairness opinions for affected portfolio companies’ valuations in order to navigate GP conflicts, although it doesn’t suggest that this process is needed in all deals.
“In certain instances, selling LPs may benefit from an independent assessment of the value of the underlying assets, together with a formal opinion stating that the cash price offered is fair from a financial point of view,” the group said. “This is relevant as the NAV is determined by the GP, and typically, a trailing number will be used for discussion purposes during the solicitation process, which may or may not be relevant to the current valuation.”
The organisation said that LPs can ask their GPs to commission the opinions, which would be conducted by independent advisers.
The guidance calls for LPACs to vet GPs’ selections of continuation fund deal advisers, including reviews of fee details, service scopes and advisers’ roles. It encourages GPs to share their adviser engagement letter summaries and commercial terms with their LPACs. The committees are in turn encouraged to review the engagement details.
ILPA said that LPACs should have the right to retain their own legal and specialist advisers for areas including valuations, structures of the processes and waivers of conflicts.
LPACs should review potential conflicts that could favour their GPs, the organisation said. It cited examples such as crystallisation of carry and methods for soliciting bids for affected portfolio companies.
LPs and GPs should not keep LPA terms that could be used to “pre-clear” conflicts in the documents, ILPA said. The practice entails bypassing consent and review processes, and has drawn ire from some LPs, affiliate title Buyouts reported in February.
Rolling LPs should also be given a “status quo” choice for continuation economic terms, ILPA said. That would bar hikes to carried interest and management fee rates, block lowering hurdles and prohibit rolling LPs from crystallising carry. Additionally, it noted that GPs should not make rolling thresholds requirements for getting status quo options.
And ILPA said that GPs should roll all their accrued carry into the funds in virtually every case. It added that GPs crystallising some of their carry should explain why, such as if people involved in their deal teams retire.
– Adam Le contributed to this report.