The SEC raise the stakes for secondaries deals

When the US Securities and Exchange Commission spent a week at New York-based private equity firm Leeds Equity Partners as part of a routine exam in January, it spent considerable time looking at a single fund stake sale in one of the firm’s existing funds.

“My understanding was that fund restructurings were something the SEC was more interested in,” Peter Lyons, Leeds’ managing director and chief financial officer, said at a recent roundtable event in New York. “That is more what I was expecting from the exam.”

Instead, the commission dug into the details of a single fund stake sale.

An LP had asked Leeds for help to sell its stake in the fund and the firm had put it in touch with parties that had previously expressed an interest. The GP then “had nothing to do with the negotiation process”, Lyons explained. “There were a lot of questions about that – wanting to know exactly what role we played in the process,” he said.

Lyons’ take was that his firm’s exam was “the tip of the spear” and that the regulator is seeking a greater understanding of the process and whether the best interests of the investors are being served.

“They were asking all the right questions,” he said. “I wouldn’t be surprised if the SEC comes out in the near future with something on secondaries.”

Lyons’ assertion – that the SEC is scrutinising how GPs handle secondaries activity – is backed up by lawyers familiar with exam processes.

Heather Stone, a partner and co-chair of the investment advisor and alternative funds group at law firm Locke Lord, tells Private Equity International that she has observed at least two instances in the last year of SEC exams featuring scrutiny of the GP’s role in secondaries transactions.

“One thing that would make the SEC uneasy is the lack of standard or best practice around the role a GP plays in these transactions. LPAs rarely contain wording about this, so the SEC will want to reassure itself that there is nothing happening below the surface that benefits the GP to the detriment of LPs,” says Stone.

The SEC declined to comment for this article.

In its 2017 examination priorities it pledged to “continue to examine private fund advisors, focusing on conflicts of interest and disclosure of conflicts as well as actions that appear to benefit the advisor at the expense of investors”.

Norm Champ, the former director of the Division of Investment Management at the SEC and now a partner at law firm Kirkland & Ellis, tells PEI he has seen the topic included in some exams with a focus on disclosure of conflicts in such transactions.

Champ believes the SEC is familiarising itself with this relatively young market but does not believe it is a “huge area” of focus. “The focus of the commission at the moment is capital formation,” he says. “Hindering secondaries – capital being able to move in and out of an asset class – would run counter to this.”

This is not the first time the SEC has sought to get under the skin of the secondaries market. In late 2015 commission officials started making public comments about the potential for conflicts of interest in GP-led fund restructuring and stapled transactions. There is plenty of scope for these processes, which are instigated by the manager, to produce a misalignment of interest. Now, however, the regulator is looking at the more straightforward, and seemingly less controversial, area of individual fund stake sales. This may come as a surprise to some, given that these processes are initiated by the LP and there seems to be scope for abuse. The owner of the stake assesses the bid or bids and decides whether or not to move forward.

So what could the SEC be worried about in these relatively vanilla transactions? Market sources suggest a few areas that could give the commission cause for concern.

One is a question of the limited partner’s motivations for selling and whether all LPs benefit from the same information. The SEC will want to be sure that the selling LP did not have knowledge that other investors lacked which motivated it to sell. If there is some sort of special relationship between the GP and that particular LP – where information could be flowing through backchannels – then that is a problem.

Another is whether the GP is being fair and transparent when suggesting buyers. It is no secret that managers will favour certain LPs over others; specifically those likely to commit to future funds. At the same time an LP looking to sell will often rely on the GP to introduce potential buyers. If the GP is selective in who they suggest, it could narrow the pool of bidders to the detriment of the investor.

If the GP itself is the buyer, then the regulator will want to see transparency around the valuation process.

A more theoretical risk concerns whether the status of a fund as a privately placed security is in jeopardy. If a fund is deemed to be publicly traded then it becomes a totally different class of security with a totally different regulatory profile. This is a long way off, says one fund lawyer, but secondaries is “a brave new world”. And with the advent of exchanges to facilitate secondaries trades, it is an area to keep an eye on.

As befits a pioneering industry, there is no standard way of handling a secondaries sale. Compliance experts tell PEI, however, that what the SEC wants to see above all else is due process and transparency.

Riding the wave

“The third wave of the established players using the secondaries market for their older-vintage funds should now really come of age and hit this year.”  Those were the words of Pablo de la Infiesta, investment bank Lazard’s former European head of private capital advisory, speaking to sister publication Secondaries Investor in January.

In the three quarters since then, several high-quality so-called ‘GP-led deals’ – transactions initiated by managers themselves – have hit the market. Such deals have taken the form of fund restructurings, which involve moving assets from an existing vehicle into a new vehicle with reset terms and economics; or stapled deals, in which a secondaries firm acquires stakes in a GP’s fund and commits primary capital to its latest fund.

Examples this year include UK buyout firm BC Partners, which launched a stapled process on its 2011-vintage buyout fund to help it hit the €7 billion target on its 10th flagship fund. The deal closed in August with Lexington Partners acquiring around $700 million worth of stakes and committing roughly $300 million to BC European Capital X.

Other well-known managers swiftly followed suit, with the Nordic region’s largest private equity firm, EQT, running a similar process. Partners Group emerged as the backer of that deal, acquiring stakes in EQT’s €4.8 billion 2011-vintage EQT VI fund and committing to its third Asia-focused vehicle. While the size of the deal remains unclear, EQT was understood to be nearing the $800 million hard-cap on its Asian fund in early September.

As this issue went to press, Secondaries Investor revealed Apax Partners, the UK’s second-biggest private equity firm according to the PEI 300 ranking, and Nordic Capital, Scandinavia’s second-largest manager, had joined the list. The firms plan to move assets from their 2007- and 2008-vintage funds, respectively, into continuation vehicles of around five years in length, allowing LPs to either cash out or roll over into a vehicle with reset terms.

While both deals remain at early stages, if they close successfully, expect to see more primary managers adding to a market where annual deal volume is expected to hit a record high this year.