Secondaries Special: Want to hire a GP?

What are the major legal challenges facing ‘GP for hire’ deals? Matthew Griffin explains

The “manager for hire” or “GP for hire” deal has become an increasingly popular approach to funding the acquisition of a portfolio of interests in operating companies, or even the acquisition of a single operating company.

The “manager for hire” deal involves a single institutional investor, or a syndicate of institutional investors, and a third-party private equity asset manager (which may be a specialist “secondary direct” manager), who form an investment fund vehicle for the purpose of acquiring interests in one or more operating companies.  This fund vehicle will generally provide for follow-on and possibly bolt-on investment capital (in some cases, the fund vehicle may also permit some “blind pool” investment). Such transactions generally fall within the category of “secondary directs” in that they involve the acquisition of interests in operating companies rather than interests in funds, but may involve (at least at the outset) the acquisition of only one interest.  

The “manager for hire” deal permits investors to enter into an incentive-based arrangement with a third-party manager to manage assets where the investors themselves may not be able to manage the assets, may not want to be involved in the management of the assets, or may not have the requisite skills, ability or proximity to manage the relevant assets.  

Investors in such deals are generally institutional investors, in particular private equity secondary funds.  The acquired interests are held in a fund vehicle to facilitate management by and payment of carried interest to the “manager for hire”.  Use of a limited partnership fund vehicle provides a flexible structure for agreeing terms with the “manager for hire”, including governance and compensation.  

There are several specialist secondary direct managers who may be appointed as the “manager for hire” – or the “manager for hire” may be a generalist private equity manager which is not restricted by its current fund documents from acting as such. 

These deals typically arise where: 

an institutional investor becomes aware of and wishes to participate (alone or as part of a syndicate) in the acquisition of interests in an operating company (or companies) without managing those interests; or
an investment team becomes aware of a deal opportunity involving the acquisition of interests in an operating company (or companies), but is not part of an investor and does not manage a discretionary fund that is able to acquire the relevant interests (this investment team may be part of a specialist “secondary direct” manager). 

The interests to be acquired as part of a “manager for hire” deal may be available for a number of reasons. For instance, they could be legacy interests held in a private equity fund that the manager is wanting to sell; they could be interests that a private equity fund manager wants to sell to rebalance its portfolio; they could be interests held by a business entity that wants to sell such interests; they could be interests that may be up for sale by a bank following foreclosures; or they could be interests that are not connected, but where synergies or integration potential could result from their acquisition.  

Other circumstances may include more conventional buyout contexts – with a twist.  For example, the management or founders of a company (including a listed company), may wish to reorganise the capital of the company to take advantage of an opportunity to acquire other companies or expand the business where funding is not available to do so through the existing capital structure.  In this case, the “manager for hire” deal may be a way of providing capital to buy out other investors (including to take a company private) and provide additional capital through a newly formed fund vehicle for acquisitions and/or expansion.  

Here, the existing management team or founders may themselves form a new entity to become the “manager for hire” (similar to a spin-out, as discussed below) and manage the acquisition/expansion process – or a third-party manager may be appointed to manage the investment fund vehicle and the operating companies it acquires (the existing management may even link up with the “manager for hire” to co-manage the assets).

There are numerous other variations on the theme.

The terms of “manager for hire” deals are invariably bespoke. They may have shorter realisation timeframes than blind-pool private equity funds, and the manager compensation is generally more incentivised than conventional private equity funds (often with budget-based management fees and stepped or accelerating carried interest based on return multiples or other out-performance measures). The terms are often investor-driven and the investors, rather than the manager, may prepare the governing documents of the fund.  Generally, there is no private placement memorandum, but a term sheet for the deal is heavily negotiated as one of the first steps in the process.  

HOW SPIN-OUTS DIFFER

Where private equity assets are held by a business entity and managed by an in-house investment team, the current owner may wish to fully or partially realise its interests in those assets through a spin-out.  This will typically involve the transfer of the assets to a newly formed fund vehicle and the spin-out of the management team into a newly formed entity to manage the fund and its assets on an ongoing basis.  

The existing owner may acquire an interest in the new fund vehicle as partial consideration for the transfer in of the assets, effectively giving the existing owner a partial realisation.  The owner may also be able, at some future stage, to sell-down all or part of its interest in the fund vehicle through a secondary transaction in its fund interest.

A spin-out involves similar issues to a “manager for hire” deal, except that the manager will have been managing the assets historically and have far greater knowledge of those assets than a newly appointed management team.  This presents interesting questions in terms of the level of due diligence to be done by investors, and the level of representations and warranties that the spun-out management team will need to give to investors in respect of the assets.  
The spun-out management team will also likely need to make a “skin-in-the-game” contribution to the new fund vehicle, which can present financing challenges to a team that has not previously held an interest in the assets that they manage.  
Similar to “manager for hire” deals, the terms of the new fund vehicle are likely to be investor-driven, bespoke, and have incentivised manager compensation arrangements.  There may also be additional commitments available for follow-on and other investment.

SOME SPECIFIC CHALLENGES

ROFRs and other pre-emption issues
One of the largest, if not the largest, challenges to executing these types of deals are rights of first refusal or other pre-emption rights, transfer consents or ‘drag and tag’ rights, which are likely to be present.  There will need to be a careful analysis of such rights and consideration of what to do if some or all of the assets are subject to them.

Regulatory barriers
Merger/anti-trust issues will need to be considered, as will the question of whether any of the operating companies are in regulated industries such as financial services, media, property or mining, in which case regulatory approvals may be required. 

Management negotiations 
In the case of a management team spin-out, the management team may find themselves in the uncomfortable position of negotiating against their current employer and work colleagues.  The management team will likely engage separate legal counsel to that of their employer, and may be on the other side to legal counsel with whom they may have worked for some time.  

The term sheet 
Considerable time is likely to be spent preparing and negotiating the term sheets for both “manager for hire” deals and spin-outs.  Although each will have bespoke terms (which are often investor-driven), there are increasingly commonalities in the commercial arrangements for such deals, including the management compensation and investor governance rights.  
Due diligence 
The investors will likely conduct their own due diligence on the assets to be acquired by the newly formed fund, although that due diligence may be less extensive than that which would be conducted were the investors to directly acquire the assets (as the investors may rely, to an extent, on the due diligence conducted by a manager for hire, or in the case of a management team spin-out, the management team’s knowledge of the assets – subject in each case to the investors verifying such due diligence to avoid the scenario of being “sold” the deal by the prospective management team).

Manager formation 
Provided they are not adversely affected, investors will typically leave the manager formation arrangements to the manager for hire or management team that is spinning out.  The management team and any new management entity may need regulatory approval, which may impact on the transaction timing. 

Fund formation 
The structure of the fund will need to be agreed at term sheet stage. While the manager for hire or management team spinning out will generally arrange the formation of the new fund vehicle, the principal governing document of the fund will often be prepared by the investor or investors.

Purchase Agreement 
This will need to be negotiated in respect of the acquisition of the operating company interests.

The above list of considerations is not exhaustive; other considerations will include tax, initial confidentiality agreements, exclusivity arrangements, continuing employment arrangements in a management team spin-out context, and arrangements in respect of debt (if applicable) including any equity support confirmations that may be required from investors as part of the provision of any third-party debt. 

Matthew Griffin is International Counsel at law firm Debevoise & Plimpton LLP