What is the biggest regulatory issue that general partners doing secondaries deals should be aware of?
GPs generally only initiate a process for secondaries sales of their funds’ interests in the context of a fund restructuring. Most such restructurings provide good options for existing fund investors who might want to get some liquidity out of a long-held investment.
The SEC is focusing on just those restructurings where it believes a GP is not providing such options to its existing LPs – for example, where the existing LP can choose only between getting dragged along to a new fund (where it may incur new or additional fees), or selling at a large discount. In these situations, the SEC is concerned that the GP is not heeding its fiduciary duty to its existing limited partners to ensure fair treatment. In fact, one SEC regulator recently stated that such situations can give LPs only “two bad choices”.
Are existing LPs drawing the short straw in GP-led restructurings?
That depends. Most PE/VC investors are quite sophisticated, and they do have options: they can roll over into the new fund – and perhaps renegotiate their management fee – or they can get out at a certain price. If they’re willing to take a risk on the performance of the remaining assets, they can tell the GP they’d be willing to roll over but only at a lower fee in the new fund.
It’s a matter of existing LPs being aware of what’s going on and flexing their muscles to ensure they’re treated fairly in restructurings. And GPs are getting the sense that they need to pay more attention to the treatment of existing LPs in light of what the SEC has said.
Is it up to the LPs to flex their muscles or can regulatory improvements also be made?
It’s a combination of both. The SEC’s statements focusing on the GP’s fiduciary duty to existing LPs in restructurings has already led more GPs to focus on disclosure and the offering of fair options. At the same time, LPs should know and exercise rights they might have under their LPAs, such as having rights of first refusal and no obligation to transfer. Also, they should ask for information about the pricing and valuation of remaining assets, as well as the restructuring plan – if it will involve a staple, or if there will be broker fees (and, if so, which party would assume such fees).
What sorts of steps can parties take to better achieve transparency in both stake purchases and restructurings deals?
This is already happening. In the context of restructurings, existing LPs are largely institutional investors who are quite savvy and have excellent counsel who know what they’re doing. They can get pretty much everything they need for a fair assessment of the GP’s valuation of existing interests, including information as to cashflow after the “as of” date. And GPs are very willing to provide all of this information – especially in light of the SEC’s recent focus on restructurings.
Third-party LPs who may purchase secondaries interests likewise seek all information that the existing LP has or can get about the fund. Transparency in this standard secondaries sale context has actually been the norm among institutional sales for some time now.
How about in stapled deals?
Staple deals have the potential for posing more conflicts of interest. For example, a GP might have a buyer who is willing to purchase both the remaining interests in the existing fund and also agrees to make a commitment to the new fund, providing the GP with a “seed” investor for the new fund. In such a situation, there may be an incentive for the GP to mark the NAV of the existing portfolio investments at the lower end of the spectrum. The LPs would then sell their interests at a larger discount than in an arm’s length transaction, while the GP gets the seed money it wants.
In addition, GPs often use “seed” investments as a marketing tool to lure other investors to a new fund. Does the GP tell other potential investors in the new fund about the staple deal? Potential institutional buyers would do their homework and know all about the performance of the GP’s prior fund. But what are they told about the seed investor? If I were an institutional buyer, I’d want to know if the seed investor had other incentives to invest that are not being offered to all other investors.
Molly Diggins joined Monument in 2011 and is based in the firm’s Boston headquarters. She was previously senior vice-president and assistant general counsel at Brown Brothers Harriman where she worked on the formation and distribution of funds.
Are restructurings an opportunity or a burden for LPs? Let me know: firstname.lastname@example.org