It has always been best practice for general partners to seek a third-party fairness opinion when transferring assets between a legacy fund that may be winding down and a continuation fund set up to acquire one or more positions. Such transactions are rife with potential conflicts of interest between all the different constituents – GPs that have a fiduciary duty to both investors in the old fund and the new continuation fund; incumbent limited partners that want to cash out at a fair price; incumbent LPs that want to transfer their interest in the asset to the new fund and, finally, new LPs buying in to the continuation fund.
With so many interested parties, an independent valuation and fairness opinion makes good business sense to the extent it makes the constituents comfortable that the transaction is fair to them from a financial point of view. It’s also prudent from a legal standpoint.
Now, however, another important party, the US Securities and Exchange Commission, is weighing in, and what was always a best practice appears likely to become a regulatory imperative.
The SEC recently proposed new rules under the ’40 Act that would require GPs to obtain – and share with interested parties – a fairness opinion from an independent opinion provider “where an adviser offers fund investors the option to sell their interests in the private fund, or to exchange them for new interests in another vehicle advised by the adviser. This would provide an important check against an adviser’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of private fund investors”.
In its proposal, the agency avers that there is a legitimate role for adviser-led secondary transactions because they can provide one group of investors with liquidity while buying time and sometimes providing additional capital to help investments to mature, thereby maximising value for investors that wish to remain in the fund.
However, the SEC also cites the potential for conflicts of interest:
“For example, because the adviser may have the opportunity to earn economic and other benefits conditioned upon the closing of the secondary transaction, such as additional management fees or carried interest.”
The proposal calls for advisers to obtain a fairness opinion that assures investors that the price being offered for the asset(s) is based “on underlying valuation that falls within a range of reasonableness”.
The proposal is part of a larger set of proposed rule changes that the agency issued in early February, which invited interested parties to submit comments due in April. While the details may change and additional implementation guidance will likely be forthcoming, the vote was 3-1, suggesting some version of the requirement is likely to be adopted.
Whatever the final rules look like, they will impact a large and rapidly growing market. According to Jefferies, GP-led transactions topped $68 billion globally in 2021, a 94 percent increase over the previous year.
Much of the increase has been driven by the pandemic and the resultant challenges in executing initial public offerings. But don’t expect the interest in continuation vehicles to fade even if covid continues to abate. Sponsors have become increasingly comfortable with continuation funds as another tool in their toolboxes, along with IPOs and sales to strategic or financial buyers. But best practice – and, potentially, SEC regulations, dictate firms use fairness opinions if they want to continue to use them.
Justin Johnson is co-chief executive and senior managing director and Chad Rucker is senior managing director at valuations firm VRC. Both specialise in solvency and fairness opinions.