This article is sponsored by Stout.
GP-led continuation funds are continuing to perform strongly – but executing a GP-led deal often brings with it significant governance implications. Kim Randolph and TJ Hope, managing directors in the valuation advisory and transaction opinions group at Stout, contend that bringing in an independent third-party financial adviser to offer a fairness opinion is a key element in a transparent GP-led process. They further comment on the US Securities and Exchange Commission’s proposed rule that would require a third-party opinion in a GP-led transaction, which, if implemented in its current form, should increase investor confidence and facilitate even further growth in the market.
Why is the market for GP-led continuation funds continuing to grow?
Kim Randolph: GP-led continuation funds have been growing at a faster rate than the overall PE secondaries market – that is primarily because they provide liquidity for LPs that want it, but also allow for continued investment for other LPs that may wish to remain in the deal, especially in companies where there is potential for additional growth. The LPs get an option for a partial liquidity or a full liquidity event in those cases. It also provides an alternative exit option – if a fund is at the end of its life, a continuation fund vehicle can extend the life and still hold on to the value of that asset by moving it into a different fund under the same GP.
There is also an opportunity to provide additional growth capital in connection with the continuation fund transaction, or raise capital to finance add-on acquisitions for the business.
What are the key governance issues that need to be addressed in a continuation vehicle transaction?
TJ Hope: There is an inherent conflict of interest in these transactions because the GP is on both sides of the deal. It oversees the selling fund and the investments within that fund, and it also oversees the newly created continuation fund. The GP will need to provide transparency in how it is going to address governance issues in the process of executing the deal. At the end of the day, the biggest question is likely going to be over the chosen value at which the business will transact. The GP is in control of that, being in control of the entire deal – so that’s a key consideration in these GP-led secondaries transactions.
How can a GP demonstrate that it is valuing the assets fairly in a GP-led deal?
TJH: One avenue for a GP to consider would be to establish a formal investment committee to review the transaction. That investment committee would be charged with doing due diligence on the company that is the subject of the continuation fund transaction, including its industry, customers, historical and expected future financial performance, risks such as regulatory and legal considerations that apply to the business, growth opportunities, etc.
Essentially, the investment committee would do everything that an investment committee would do if the GP were buying a company for the first time. The idea here is obviously to make sure there is a formal and thorough review process. This will give greater comfort not only to those LPs that are rolling funds from the existing fund to the new continuation fund, but also to those investors that are coming in for the first time and those who are selling.
KR: The GP will often maintain an internal mark on valuing the company. It is important to have documentation showing how it arrived at that mark and how the valuation changed over time. A change in the valuation, particularly if it’s in favour of one party over another, would need to have some substantive reasoning to back it up.
What role can independent third parties play in offering reassurance to stakeholders in these deals?
KR: The GP will often hire an independent third party to provide a fairness opinion. The provider would assess whether the transaction is fair from a financial point of view to certain parties in the transaction, particularly those that are cashing out or are not being given an opportunity to stay in. The fairness opinion can augment the GP’s own due diligence process and help provide assurance that the transaction is fair from a financial point of view.
What factors should GPs consider when choosing a firm to provide a fairness opinion?
KR: The GP will want to make sure that the firm is a qualified provider that has significant valuation and fairness opinion experience. The provider needs to have real world experience in valuations and should be able to demonstrate comprehensive diligence and empirical research behind the opinion that it provides. Ultimately, the opinion delivered by the provider needs to be able to withstand the scrutiny that might come from the shareholders, or the SEC, or whomever else may challenge the opinion in the future.
TJH: Also, it is key to look at the procedures that have been put in place to execute and review the opinion before it is issued. There is a Financial Industry Regulatory Authority rule that pertains to how fairness opinions are executed in public company transactions – among other things, it requires the firm providing the opinion to have a committee composed of qualified professionals that reviews the opinion before it goes out.
At Stout, we adhere to that rule in every opinion that we issue, whether it’s in the private or public markets. We have a committee, consisting of individuals who have deep valuation and M&A experience, that is completely independent of the deal team that is working on the engagement. Every opinion we issue has to be reviewed by three members of that committee. They provide a thorough review of the analysis that was done by the deal team, and they scrutinise the assumptions and methodologies that were used in doing the valuation and preparing the opinion.
“The fairness opinion can augment the GP’s own due diligence process”
How could the SEC’s proposed rule on obtaining a fairness opinion affect the GP-led market?
TJH: The rule covers advisers to private funds and aims to make sure there are adequate protections in place for investors. It is still in the comment period, but – as currently drafted – for GP-led secondaries deals, the rule would require that either a fairness opinion or a third-party valuation be prepared in connection with that transaction. In its release around the proposed rule, the SEC noted that having such a requirement would provide a check against those inherent conflicts of interest in GP-led secondaries deals.
The rule should be welcomed, especially from an investor perspective. It will help ensure that the process is fair and the price at which the GP chooses to transact is also fair. There has already been huge growth in secondaries fundraising, but this rule could augment that growth. Strengthening protections for investors could ultimately increase the velocity of transactions and fundraising in the secondaries market.