As the secondaries market reaches a certain maturity and a certain size – with about $40 billion transacted annually – more legally complex transactions such as tail-end sales, preferred equity deals and GP-led deals are emerging and gathering popularity with buyers and sellers alike.
Mike Suppappola, a partner in Proskauer’s Private Investment Funds Group in Boston, and Kate Simpson, a partner in the firm’s Private Investment Funds Group in London, explain some of the best approaches to these types of transactions.
What are some of the reasons for the growth in tail-end sales and some of the legal challenges with those transactions often aiming at winding down a fund?
Mike Suppappola: As we see funds from 2004, 2005 and 2006 coming to the end of their life, more secondaries firms and funds of funds are taking advantage of the secondaries market to wind down these old funds that may still hold a large volume of underlying fund interests.
Often, there are going to be complexities under applicable law that need to be navigated in order to liquidate the fund. Under Delaware law, you can’t really hold a final liquidation of your fund unless you make contingencies for all the fund’s liabilities. A lot of funds are very reluctant to pursue escrows or insurance to cover residual liabilities. For that reason, the seller often wants the buyer to agree that seller liabilities under the purchase agreement only last for a finite period so that the selling fund can liquidate in a timely manner. The buyer may accept those terms but want to price in any additional liability risk. Liquidation is the end goal of most sellers involved in these tail-end sales.
Kate Simpson: We are seeing a similar situation in Europe – managers looking to the secondaries market as a liquidity solution for end-of-life funds. Their portfolios often contain a wide variety of assets including straight fund interests along with more unusual assets distributed when underlying funds have themselves liquidated, such as derivatives or third-party managed securities, which can create challenges during the process. Once the assets are sold, the focus shifts to winding up the fund structure which is not generally sold as part of the transaction and this can itself take some time.
Do you see tail-end sales continuing to make up a substantial share of the secondaries transactions volume?
KS: Tail-end sales now form part of the range of liquidity solutions which firms will continue to pursue as long as these transactions are available. There are buyers who find these attractive and have created a niche in the market.
Preferred equity transactions are also gaining traction in the secondaries world, can you give some examples of what these deals may look like?
MS: Preferred equity purchases are a relatively recent phenomenon. If a GP is looking to provide liquidity to its LPs, it might cut a deal with a preferred equity provider whereby the fund’s assets are transferred to a newly formed SPV that’s owned by both the fund and the preferred equity provider. The preferred equity provider provides liquidity to that SPV, which is then distributed out to the LPs in exchange for future preferential cashflows from the portfolio to the preferred equity provider under a negotiated distribution waterfall at the SPV level. In that scenario, it’s really a way to get the LPs cash right away, operating similar in some respects to a dividend recap in the buyout world.
You also have the same types of preferred equity providers working with secondaries buyers. They may offer to provide equity financing to a buyer in exchange for preferred cashflows from the purchased portfolio. The preferred equity providers would typically only make money if the portfolio does well and continues to produce returns, which aligns interests and provides an alternative option if a seller won’t accept a deferred purchase price arrangement and pursuing a line of credit isn’t a viable option for the buyer under the circumstances.
What other types of more complex secondaries transactions are you also seeing?
MS: I do see a lot of structured secondaries deals. A secondaries fund might purchase a direct portfolio of interests and the seller wants continued participation in any upside in the portfolio. The seller will participate with the buyer in an SPV and they will negotiate a split of the cashflow whereby the seller will receive distributions if portfolio returns exceed a certain hurdle or other threshold. It’s similar conceptually to preferred equity, but it’s a slightly different way of thinking about it. The seller isn’t contributing additional capital to an SPV, but it would be getting the potential for future profit, typically in exchange for a reduced purchase price.
Another common type of structured secondaries we see involves secondaries buyers purchasing a direct portfolio of buyout or venture interests. The buyer creates a structure whereby it is the sole LP of a newly formed investment vehicle and it brings in a third-party manager. They are essentially wrapping a fund around the acquired portfolio so that the secondaries buyer can capture the economics but then pay someone else to provide the expertise on managing the direct assets.
KS: In addition to those direct deals, we are also continuing to see GP recapitalisations and restructurings where a liquidity solution is offered to existing investors by a buyer which may also be putting extra capital into the fund and/or providing investment into a new vehicle from the manager. These transactions can also involve resetting economics for the manager itself. They are increasingly attractive as they can offer upside to all parties – they offer investors immediate liquidity and allow them to rebalance their portfolio, they provide access to a known pool of assets for the buyer and afford the manager an opportunity to realign economics and potentially gives them fresh capital to support the portfolio.
What are some of the legal challenges associated with these transactions?
KS: These transactions can be very complex as they involve multiple competing interests. Any decision to restructure and offer existing investors a liquidity option and/or an option of continued participation creates an inherent conflict for the manager. Particularly if the economics are reset, it is, in essence, a transaction with the manager on both sides. Accordingly there needs to be an in-depth analysis of the fund documents and the transaction to determine the impact of the structure, the potential risks and the necessary waivers and approvals.
Ultimately it will likely come down to a question of value. The buyer will want to negotiate a good deal whilst the investors, and indeed any former executives of the manager still holding carried interest, will want to ensure as high a price as possible. As the manager is operating on both sides of the deal – as manager of the fund being restructured and of the new restructured buyer vehicle – it must tread a fine line to ensure all parties are fairly treated. Fundamentally a transparent process and seeking parity of treatment are key.
This article is sponsored by Proskauer. It appeared in the September issue of Private Equity International.