When secondaries go wrong: What the lawyers think

The secondaries market is buoyant, but market participants would be wise to suppress their exuberance. The next downturn will be the first major test of the GP-led secondaries market – processes initiated by fund managers.

When funds’ net asset values drop and LPs who rolled their interests into their GP’s continuation vehicle start to think they should have sold their interests instead, there could be legal implications.

“It’s not unreasonable to expect some stakeholders will look at ways to reverse some of those processes or recover some of the losses they might have suffered,” says a London-based fund formation partner. “That’s when people will start focusing more on how these deals were done, what was said and what was not said.”

Legal sources outline the questions aggrieved LPs will ask:

• Did the GP satisfy its fiduciary obligations?
• Was there an undisclosed conflict of interest on the part of the GP?
• Did the GP comply with the limited partnership agreement by seeking advisory board approval?
• If not, is the LP entitled to damages?

At one end of the spectrum are prudent secondaries managers who try to mitigate potential risks by testing the market, running an intermediated process, keeping LPs involved and disclosing fully. At the other are managers taking a less robust approach to conflicts and relying simply on the fund’s LPAC for approval.

“Somewhere on that range, the regulator may zero in,” says Aleks Bakic, a partner at Akin Gump who focuses on private funds and secondaries.

Moves are already afoot to prepare for an increase in legal risk and the LPAC is the canary in the coal mine. The Institutional Limited Partners Association, which published its latest Principles 3.0 in June, is set to focus its next standalone guidance on LPAC best practices and is expected to cover GP-led secondaries within this.

LPAC members walk a tightrope. They want to represent the interests of the fund’s LPs without taking responsibility such that it brings into question their status as “limited” partners – and by extension their limited liability – says Ted Cardos, European head of Kirkland & Ellis’s secondaries practice.

It has become common for LPACs to hire their own legal counsel and demand that a GP seek a third-party valuation opinion, both at the fund’s expense. Several funds lawyers to whom PEI spoke said a growing number of LPACs are refusing to make a judgement on GP-led deals and instead throw them open to the whole LP base.

“It’s not impossible to envisage the role of the LPAC being replaced by some other mechanism, an independent expert or something like that,” adds Bakic.

This article first appeared in sister publication Private Equity International‘s September secondaries special.