How to structure a secondary

In many ways, a private equity fund secondary transaction is similar to a corporate M&A deal. However, secondary transactions differ in several significant respects, principally as a result of the character of the asset being transferred – namely, a limited partnership (or other similar fund) interest. The principle aspect of that character is illiquidity. And this illiquidity is no accident: when launching a fund, general partners expect investors to be in for the life of the fund and, although transfers are possible, life is deliberately not made easy for the limited partner who chooses to exit.

There are some key considerations for LPs who want to exit and, while the deal is struck between the exiting LP and the buyer, GPs play a pivotal role in facilitating the transaction while protecting the interests of other LPs and themselves.

APPROACHES
Limited partnership agreements (LPAs) will invariably require that the seller obtains GP consent to the transfer and to the prospective buyer becoming a substitute LP. Although the GP is often required to act reasonably, in practice GPs have broad discretion in this regard. GPs will typically prefer an institutional buyer that has the potential to commit to new funds it may launch in the future, rather than a secondary fund which is unlikely to be interested in primary investments in follow-on funds. So the GP has a vested interest maintaining an active role in the sale process and more proactive GPs will often attempt to line up “friendly” buyers when faced with an LP that wishes to exit. The exiting LP will be well advised to engage with the GP at an early stage so as to reduce transfer risk and preserve its relationship with the GP.

RIGHT OF FIRST REFUSAL
A significant proportion of funds contain right of first refusal (ROFR) provisions, affording the GP and/or the existing investors an opportunity to acquire the selling LP's interest on the same terms offered by the prospective buyer. This may have a depressing effect on the price of the individual interests in question (and may deter prospective bidders from making an offer) and, in any event, will extend the time it takes to transfer the interest. In the case of the sale of a portfolio of LP interests, sellers sometimes attempt to circumvent ROFR provisions by allocating an artificially high price to the interests subject to an ROFR and lower prices to other interests.

BIDDER DUE DILIGENCE
In common with other acquisitions, bidders will require a period of legal and financial due diligence. They will typically require access to quarterly and annual financial reports and valuations as well as to the constitutional and other contractual documents relating to the fund and the appointment of the manager and/or adviser.

Prospective buyers may also want to see all drawdown and distribution notices and capital statements so as to reconcile the financial position of the investment and quantify the future liability to contribute capital. The legal documents will include the original LPA (and amendments), subscription agreement, private placement memorandum, any side letters negotiated with the seller (and those with the other investors) and any legal opinions.

Buyers' diligence requirements will vary. Some will be satisfied with a desktop valuation restricted to available documentary information. Others employ a highly granular “bottom-up” approach and attempt to value each portfolio company and assess the likelihood of it reaching a successful exit.

In common with primary investors in private equity funds, a secondary buyer will also place significant weight on the skills and track record of the GP/fund manager and individual members of the management team.

Care should be taken to check whether stamp duty or other transfer tax is chargeable on the transfer of an interest in the fund

Current over-supply in the secondary market has led to bidders in auctions demanding cost coverage at the commencement of the due diligence phase. This may take the form of a break fee or indemnity for a pre-agreed level of costs in favour of the bidder. Whilst unpalatable for a seller, it may well be the price it needs to pay in the current environment to bring bidders to the table.

Understandably, GPs are sensitive about the sharing of confidential information between seller and buyer in the due diligence process. Not only is the information often commercially sensitive, but the GP will also owe a fiduciary duty to other investors which they take seriously. Any due diligence should therefore be preceded by the execution of a full non-disclosure agreement (NDA), which should be written for the benefit of the GP, whether or not the seller has informed the GP of its intention to sell at that stage.

For a portfolio sale, it is not unusual for a seller to want to delay notifying or engaging with the GP until it has reached a binding deal with the buyer, in which case the existence of an NDA in favour of the GP should help to reduce the risk of the GP refusing its consent to the transfer once it is informed.

SALE AND PURCHASE AGREEMENT
Where interests in more than one fund are being sold, the buyer and seller will typically enter into an umbrella sale and purchase agreement (SPA). A consequence of the restrictions on transfer in fund LPAs is that signing of the SPA and completion of the transfer will not be simultaneous. Rather, the SPA will contemplate a completion (or, in the case of a portfolio sale, multiple completions) which will occur once the restrictions on transfer in each LPA have been satisfied or waived.

The SPA should contain a mechanism to carve out those interests that are taken up by other investors under ROFR provisions or excluded because of lack of GP consent. However, buyers may not always be willing to proceed with the purchase of a portfolio that has been pared down in this way.

The SPA will contemplate individual assignment and assumption or other transfer agreements being entered into and exchanged at completion (the form of which will either be prescribed by, or drafted with the assistance of, the GP for the relevant fund). The SPA will need to identify clearly what liabilities are being assumed by the buyer; for example, the liability to meet all future capital calls and to contribute capital that has been returned but is still subject to recall (the latter being a liability which buyers tend not to want to take on). The seller will want to achieve a clean break and it is not always sufficient to rely on the allocation of liabilities under the transfer mechanisms in the LPA to achieve this.

Current over-supply in the secondary market has led to bidders in auctions demanding cost coverage at the commencement of the due diligence phase

The SPA will also contain contractual comfort for the buyer regarding the quality of the interest being transferred (in the form of warranties) and the preservation of value of the interests between signing and completion, which may be several months (in the form of pre-completion covenants from the seller to the buyer). Buyers will typically request a certificate from the GP of the fund confirming capital contributions and distributions made to date. However, GPs are not always obliged or prepared to provide such comfort to a buyer, who may be left to rely on contractual comfort from the seller under the SPA.

As in a traditional M&A transaction, a seller will want to have the opportunity to disclose against the warranties. This will be particularly important for distressed or liquidity-constrained sellers who may have to disclose irregularities in relation to meeting capital call notices during the months leading up to the sale.

It is important to understand the legal character of the LP interest being transferred to ensure that the correct procedures are followed to effect the transfer of the legal title to the buyer.

In some jurisdictions, legal or regulatory provisions governing limited partnerships prescribe the method and timing of the transfer of legal title. For example, in the case of an interest in an English or Scottish limited partnership, a notice of the transfer must be published in the London or Edinburgh Gazette respectively before the transfer is effective.

SYNTHETIC SECONDARIES
Whether for legal or commercial reasons, it is not always desirable or practical to effect a transfer of the legal title to a fund interest and other structures are therefore sometimes employed to achieve the seller's objective of scaling back or exiting its investment in a fund. Synthetic structures cover a range of transactions where the buyer acquires only the beneficial or economic interest in the underlying fund.

One option is a structured joint venture between buyer and seller where the fund interests are transferred to a special purpose vehicle, the shares in which are held by the seller and buyer. Alternatively, the LP may decide to sell a “horizontal strip” of its entire portfolio, for example contracting with the buyer to pass, say, a 25 percent beneficial interest in a portfolio to the buyer in return for the buyer promising to contribute an equal proportion of the future capital commitments – thereby maintaining relationships and sub-class weightings, but reducing overall exposure for the seller. These structures are not without their risks since they rely on an active contractual relationship between buyer and seller for the remaining life of the funds in the portfolio (which could be 10 years or more).

For any synthetic secondary, care must be taken to check if the transfer provisions in the LPA prohibit such transfers. Somewhat surprisingly, LPA provisions for the majority of private equity funds do not (as yet) prohibit most synthetic transactions and, consequently, GP consent may be dispensed with (although, for relationship reasons, the parties may still wish to obtain the informal approval of the GP to the transaction).

TAX
In most jurisdictions fund entities are fiscally transparent. This means that for tax purposes, the disposal of an interest in a limited partnership is likely to be treated as a disposal by the LP of its fractional share in each of the partnership assets.

The fractional share of the limited partnership assets which an LP owns is determined by that partner's entitlement to profit. Consequently, the profit entitlement also determines the portion of the gain (or loss) arising from the disposal of the limited partnership asset that an LP is taken to receive. It also determines the acquisition cost of the asset that is apportioned to the LP.

The LP disposing of the interest will likely only be liable to pay tax on any resulting chargeable gain in a particular jurisdiction if it is within the scope of tax in that jurisdiction. Special rules may apply to limited partnerships which have corporate members, however.

Regardless of the tax residence or status of the selling LP, care should be taken to check whether stamp duty or other transfer tax is chargeable on the transfer of an interest in the fund. Different jurisdictions have different rules in this regard.

James Burdett is a partner at Baker & McKenzie and he ads the firm's Investment Funds Group. To subscribe for regular briefings on the sector, please email james.burdett@bakernet.com.