A fund term that is riling up much of the limited partner world would provide ‘pre-clearance’ of conflict of interest in GP-led secondaries deals, skipping the usual review and consent process by the limited partner advisory committee, sources told affiliate title Buyouts in recent interviews.
Some GPs have been pushing to codify the term in the limited partner agreements of new funds, sources said. LPs that spoke with Buyouts have almost universally pushed back against the term, arguing the LPAC should always have its chance to review potential conflicts and clear them before a deal proceeds. All sources who spoke with Buyouts said they have not yet seen a secondaries deal hit the market that is relying on pre-clearance.
“At a high level, you’ll see more LPs that would be frustrated and not like this idea of pre-clearance of continuation funds,” says Neal Prunier, senior director, industry affairs at the Institutional Limited Partners Association. “For the most part, LPs want these to go through the LPAC [so they can] have that dialogue and see more transparency and rationale provided by GPs.”
Pre-clearance represents what some LPs see as GP overreach on fund terms that became endemic during the fundraising bull market. Terms and conditions represent one of the major pressure points in the LP/GP relationship, and the power in negotiating such terms swings to either side depending on the economy and strength of the fundraising market.
The power has mostly resided with the GP over the past few years, when fundraising was breaking records and many GPs were able to hit their targets. As fundraising slows, however, some LPs are re-examining terms they felt distorted their relationships with PE managers.
“There [are] some terms that skewed a little bit out of whack toward the GPs’ favour in terms of fairness and we’re looking to bring those back to the centre,” said Scott Ramsower, head of private equity funds at Teacher Retirement System of Texas, in an interview with Buyouts late last year.
The issue gets to the heart of the nature of the LP/GP relationship, and the true scope of the LPAC. What is its purpose if not to weigh in on issues of potential conflicts and communicate those concerns down through the LP base?
“There has to be a basis for LPs to trust the GP is acting in their best interests. The advisory board is there to ensure that someone is watching and keeping GPs accountable in light of all the discretion they have on a blind-pool basis to find deals,” says Kari Harris, chair of the investment funds practice at law firm Mintz.
A change in language
The issue involves GP-led deals because of potential conflicts of interest, which brings such transactions under the purview of the LPAC. It’s become more significant as GP-led deals have exploded in popularity over the past few years.
The secondaries market last year tallied about $103 billion of total deal volume, a drop from 2021’s record year of more than $130 billion. GP-led deals represented about 46 percent of that, according to Evercore’s full-year 2022 volume report.
GPs have become enamoured of these deals. GP-led transactions, in one shot, provide a partial exit of an investment, delivering proceeds to LPs and allow the GP to hang on to a treasured asset for longer than allowed under the confines of a traditional PE fund. They could prove especially valuable in this environment of slower exit activity, with GPs looking for ways to distribute to liquidity-starved LPs.
Continuation fund deals require a conflict of interest waiver by the LPAC because the GP is on both sides of the deal, as it is selling the asset to itself. Disclosure and resolution of the conflict falls under a GP’s duty of loyalty to its fund investors under the Investment Advisers Act.
“At a high level, you’ll see more LPs that would be frustrated and not like this idea of pre-clearance of continuation funds”
The LPAC must decide if the GP has run a transparent process with something close to a fair price such that LPs can be comfortable with the firm as buyer and seller. Once the LPAC approves the conflict waiver, LPs then decide whether to sell or roll in what is known as the election period.
Pre-clearance would bypass the LPAC conflict waiver process and move the deal directly to the LP election period. Under the pre-clearance terms that have been proposed, it would only apply to deals under certain circumstances.
The ‘certain circumstances’ is an important distinction. This generally involves assets that were in competitive bidding processes, had sold a minority stake through which it achieved a market price prior to the secondaries process, or were subject to fairness opinions, according to Kelly Labritz, a partner at Clifford Chance.
It also would require the GP to offer LPs options in such deals and to ensure LPs are not being disadvantaged in a secondaries transaction as opposed to a straight M&A sale, Mintz’s Harris says.
Says Labritz: “If that’s one of these situations, then maybe this is a transaction that arguably would not need to be approved in terms of conflicts.”
This doesn’t absolve the GP from running a transparent process, sources said. Instead, vetting of the valuation and rationale for the deal would fall to each individual LP as part of their decision whether to sell or roll into the continuation fund.
In essence, pre-clearance removes responsibility from the LPAC for giving its blessing to the deal, and puts it on every LP in the fund. Each LP can then vote by either selling or rolling.
The change has come gradually over the last year or two with a shift in language in the LPA. For many years, language focusing on continuation fund deals in LPAs comprised “no more than a decent-sized paragraph” that alerted the LP base that it could pursue such a deal in the future and laying out the process the GP would follow. That process included getting LPAC consent and approval on the deal that included some form of price validation.
Pre-clearance comes through an expansion of the language to indicate that in some cases, the GP doesn’t have to follow that process. As long as the price has been validated, and as long as the LPs are offered practical options and the terms are no less favourable than would be obtainable from a third-party buyer, “then we don’t even need to go to the LPAC; you will be deemed to have consented in advance”, Harris says.
The change has come about as a way to ostensibly smooth out the GP-led deal process, which for many LP institutions can represent a burden, especially if they have multiple transactions in their portfolios.
In some cases, the LPAC may want to be absolved of the responsibility of consenting to a deal. “With continuation fund deals, the LPAC is really making a huge decision for their co-LPs,” Labritz says. “There have been cases where the LPAC is not really keen to lock in all of the other LPs.
“An LP might like to consider the option of cashing out or rolling and wouldn’t want its ability to consider all possibilities squashed because of an LPAC vote. LPs want to be able to look at the deal and whether it’s fair to them, as opposed to having others on the LPAC who have a different investment position decide if they even get to consider whether they want to sell or roll.”
Some LPs have developed checklists over the years they use to assess deals and determine whether they will sell or roll. They would still be able to do this even in pre-clearance scenarios, according to Labritz.
“Once the LPAC has consented to the deal and waived the GP’s conflicts, the deal generally is cleared to proceed and the LP body as a whole generally no longer has a say about that. But each LP still gets to independently decide whether to roll, or take their cash and go home,” she says. “An LP’s own checklist will be tailored to their own needs and investment position and help them determine which choice is right for that particular LP.”
However, critics counter that the review and consent process provides an opening for broad communications about not only the process and pricing of the deal, but its rationale.
Even with pre-clearance in place, a GP could still openly communicate with the LPAC about its rationale, but the point is that with pre-clearance, that opening is not there, according to Brian Hoehn, a senior associate at ILPA.
ILPA’s Prunier says: “The LPAC can express its discomfort with the transaction and have the GP think about, is this the best thing for alignment when we’re going to be fundraising in 12 or 18 months and we’re engaging in a 10-year relationship.”
“There has to be a basis for LPs to trust the GP is acting in their best interests”
Down the line
Another question with pre-clearance is whether it would still be relevant to an asset or assets five or 10 years after a fund launch, says Clifford Chance partner Bill Sturman. The inclusion of a pre-clearance term in a fund LPA does not automatically mean it’ll be put to use in future GP-led deals.
“It’s almost impossible to predict all the details and specifications of these deals,” says Sturman. “They are very bespoke transactions, so [it’s hard] to incorporate all the material terms and issues LPs will be consenting on.”
Indeed, critics believe pre-clearing a deal not even conceived of yet seems like a stretch. Among them is Harris: “We have this LPA provision that says, ‘Even though we all acknowledge this is a material conflict – a cross-trade between affiliated funds – nonetheless, we’ll try to, on day one of a 10-plus-two-year fund, have you agree that a portfolio company we haven’t even sourced yet eight years from now we can sell to ourselves and don’t have to jump through these hoops.’ I don’t see the market going that way.”
Another concern is increased scrutiny from the US Securities and Exchange Commission, which is focusing more on continuation fund deals. Proposed rules last year, which are expected to be finalised in some form this year, would more strictly regulate continuation fund deals.
Pre-clearance of conflicts would seem to be another red flag that could invite more SEC scrutiny, sources said. If a GP uses pre-clearance, they need to be even more aware of their valuation process for a GP-led deal, says Sturman.
“Even if pre-clearance would allow a GP to do a deal without getting separate consent, it doesn’t mean the GP can run into town, do a GP-led and not answer to anybody,” says Labritz. “All of the fiduciary, contractual and other duties would still apply. Arguably, you’d have to be even more careful because no one is looking over the GP’s shoulder and helping to resolve the conflicts.”