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.
In this first part of our Q&A with law firm Proskauer, Mike Suppappola and Kate Simpson discuss the legal challenges surrounding tail-end sales and the rise of preferred equity deals.
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.
Mike Suppappola and Kate Simpson are both partners in Proskauer’s Private Investment Funds Group based in Boston and London respectively.
This article is sponsored by Proskauer. It appears in the September issue of Private Equity International magazine.