Secondaries transactions: the lawyers’ take

Ropes & Gray’s Raj Marphatia and Frank Williams examine the legal points buyers and sellers should consider when making secondaries deals. In this first part of a chapter from The Secondaries Market, they look at the Purchase and Sale Agreement.

This chapter focuses on the key legal issues that arise in connection with a secondaries transaction. Once a buyer and a seller have signed a term sheet or letter of intent (almost always a non-binding document) outlining the basic elements of the transaction (pricing and payment schedule), the next step is to memorialise their agreement in a definitive legal document, which is typically referred to as the Purchase and Sale Agreement (the ‘PSA’).

General purpose of the Purchase and Sale Agreement

The PSA is a binding legal document and establishes enforceable contractual obligations on both the buyer and the seller regarding the purchase and sale of the limited partnership interest(s) being transferred (the ‘interest’) in a particular fund (the ‘fund’).¹ The basic agreement is that the buyer will:

• purchase the interest from the seller in exchange for a cash payment at closing; and
• assume certain specific obligations of the seller relating to the interest, most notably the seller’s unfunded capital commitment to the fund with respect to the

Described below are the critical issues that arise when negotiating a PSA, including purchase price adjustments, deferred purchase price payments, the role of the fund, representations and warranties, excluded obligations, closing conditions, indemnification, expense allocation, and specific performance.

The purchase price for the interest is typically expressed as a percentage of the capital account balance of the seller with respect to the interest as of a particular date (the ‘reference date’). The capital account balance, or net asset value of the interest (the ‘NAV’), is determined by the fund, and the reference date is typically the most recent date for which an NAV is available (usually a quarter end). The interest may be sold at a premium or discount relative to the reference date NAV, depending on the parties’ evaluation of the accuracy of the NAV and their negotiating leverage, and the relative scarcity of the interest.

The purchase price is then further adjusted for cashflows following the reference date. Capital contributions funded by the seller from the reference date to the date on which the interest is transferred (the ‘closing date’), including cashflows after the date on which the PSA is signed, increase the purchase price. Distributions received by the seller during that period decrease the purchase price. The economic ownership of the interest is effectively transferred to the buyer as of the reference date.

As many deals in today’s market are of assets denominated in foreign currencies, the PSA should also address:

• the currency in which the purchase price is denominated; and
• if applicable, the foreign exchange rate to be used in any

To minimise exchange rate disruptions, it is not uncommon for the purchase price to be paid in more than one currency, if the interests being sold are denominated in different currencies.

Deferred payment of purchase price

Deferred payment of the purchase price has become a popular technique in recent years to bridge gaps in pricing between the buyer and seller. In the vanilla case, the seller transfers the asset to the buyer for an initial payment, and the balance of the purchase price will be paid over a period of one to two years.

While a deferred purchase price arrangement is generally a commercial issue, legal issues are immediately encountered, given that the seller must assume the buyer’s credit risk, particularly when the deferred purchase price is a significant portion of the buyer’s net assets or when the buyer is a special purpose vehicle (SPV) that has no other assets.

While this issue is occasionally waved away, given the reputational harm that a non-paying buyer would incur, sellers typically push for either a guarantee or escrow of the purchase price (with the guarantee being the much more common of the two approaches).

In addition to the buyer SPV contractually agreeing to pay the purchase price, an upper tier buyer entity with more significant assets is required to guarantee the buyer’s payment obligations. This guarantee is typically accompanied by:

• information rights for the seller;
• certain representations and warranties regarding the financial condition of the guarantor; and
• acceleration provisions in the event of default by the buyer.

Role of the fund

Although the PSA is a bilateral contract between the buyer and seller, there is one other important constituency that plays a critical role in a secondaries transaction — the fund with respect to which an interest is being transferred.

Most fund agreements do not allow a limited partner to transfer its interest in the fund without the consent of the general partner. Such consent may typically be given at the sole discretion of the GP. The seller, as a result, must work closely with the GP to ensure the proposed transfer to the buyer is approved. This approval is typically documented in a transfer agreement, which is a tripartite contract between the seller, the buyer and the fund. This contract is typically negotiated and executed after the PSA is signed, and is usually one of the key conditions to the closing of the transaction. In addition, the following two fund-related complications should be noted:

1. Rights of first refusal included in the fund’s partnership agreement. Under this provision, an LP wishing to transfer its interest in the fund must give notice to the other partners of the fund of the interest it is proposing to sell and the price at which it is proposing to sell. This is to allow the other partners the opportunity to buy the interest at that price. If this right is exercised, the contract between the seller and buyer with respect to the interest is effectively pre-empted, and the sellers must take care to notify the buyer of any such provisions. To avoid having their contract pre-empted in this way, buyers of a portfolio of interests often price the individual interests in a way that allocates more of the purchase price to interests that are subject to a right of first This type of purchase price allocation can be risky for sellers because if the interests subject to a right of first refusal cannot be sold, sellers remain contractually obligated to sell the other interests at a price that is potentially less than their fair market value.

2. Publicly traded partnership rules. A full discussion of these rules is beyond the scope of this chapter, but these tax rules essentially tax a partnership as a corporation if interests in the partnership are deemed publicly traded. Tax regulations provide safe harbours, enabling a partnership to avoid these rules. A limited trading exemption² is one such safe harbour. Funds relying on this exemption may limit transfers in any given year to fit within the limited trading safe If this is the case, the fund may insist on delaying the effective date of the transfer proposed under the PSA. A shrewd seller will contact the GP early in the process to determine whether the fund relies on the limited trading safe harbour and, if so, whether this might result in a delay in the effective date of the transfer.

¹ For the purposes of this chapter we generally assume that a single interest is being transferred, except where otherwise noted. Of course, the ‘interest’ may be a limited liability company interest, exempted limited partnership interest, or interests in other types of vehicles.

²26 CFR 1.7704-1(j).