How the SEC views conflicts in GP-led restructurings

Staff at the US Securities and Exchange Commission (SEC) reiterated last week that they are watching end-of-life funds closely and studying how general partners are dealing with zombie situations.

“The interesting industry forces that we see today have to do with fundraising and end-of-life funds,” Igor Rozenblit, co-head of the Private Funds Unit at the SEC, said at the PEI 2016 CFOs and COOs Forum in New York.

“We are coming out of a strong fundraising market and those that have not been able to raise capital in the current market might be tempted to resort to creative approaches in markets that are less favourable,” Rozenblit said. “We are watching to make sure that those creative approaches don’t cross the line and violate federal securities laws.”

Some mid-market funds raised in 2002 and 2003 are now past their extension periods and GPs may be tempted to turn to the secondaries markets, particularly through GP-led restructurings or stapled secondaries transactions, to return cash to their limited partners and to raise fresh capital.  While there is nothing inherently wrong with those transactions, they are rife with conflicts of interest which need to be effectively managed.

“I’ve talked before about GP-led fund restructurings and stapled secondaries, the pressures of those transactions and effects that they have on investors,” Rozenblit said. “That would likely be an issue, but fees and expenses in zombie situations are also on the radar.”

There are numerous issues regarding zombie managers, or managers who are unlikely to raise additional capital. One example is GPs who operate their funds in liquidation mode without getting fund extensions.  In this period, the manager can increase monitoring fees and transaction fees with the existing portfolio absorbing the expenses.

The Fenway Partners case is a good illustration of how such conflicts of interest can arise. In the case, Fenway rerouted portfolio company fees to an affiliate and failed to provide the benefits of those fees to LPs in the form of management fee offset. The case was settled last November with the firm and four executives paying over $10.2 million for failing to disclose the conflict of interest.

“I think the general takeaway from that case is that these kinds of things are actually not that uncommon when funds enter zombie mode, and this is what makes zombies particularly of interest to us,” said Rozenblit.

“There are a number of techniques that managers can use when they have decided that they no longer value their LP relationships, including creating third-party providers to charge fees to funds or clients.”

He added that in GP-led restructurings, GPs can try to negotiate a way to get clawbacks, while others try to charge transaction fees and broker fees resulting from GP-led restructurings to their LPs.

“While we will be vigilant at detecting fraud and securities laws violations, in many cases it will be up to investors to navigate some of these stressful end-of-life situations. Investors shouldn’t be afraid to band together and fire their manager if their assets aren’t being managed appropriately and they shouldn’t be afraid to report fraud to the SEC if it occurs,” Rozenblit said.