Secondaries transactions: making sure you’re covered

In this second part of a chapter from The Secondaries Market, Ropes & Gray’s Raj Marphatia and Frank Williams look at the types of representations and warranties, excluded obligations and indemnifications that may appear in Purchase and Sale Agreements.

Ropes & Gray’s Raj Marphatia and Frank Williams examine the legal points buyers and sellers should consider when making secondaries deals. In this second part of a chapter from The Secondaries Market, they look at the types of representations and warranties, excluded obligations and indemnifications that may appear in Purchase and Sale Agreements.

To read part I, click here.

Representations and warranties

While the scope and breadth of  representations and warranties vary from PSA to PSA, it is unsurprising that those relating to the economic dimensions of the interest being purchased are the most important. It is critical for the buyer to understand the size of the interest it is acquiring, and the size of the obligations it is assuming. Consequently, the buyer requires the seller to provide representations regarding its:

    • original capital commitment to the fund;
    • remaining unfunded capital commitment; and
    • capital account balance.

The buyer also requires the seller to specify exactly which contracts it is assuming as part of the transaction.

Negotiation of these points focuses on whether the seller can provide the representations with a ‘knowledge qualifier’ (that is, to the seller’s knowledge, based on information provided by the GP, the information is correct). While the buyer prefers unqualified representations in all respects (that is, flat), the capital account balance and remaining unfunded capital commitment representations typically end up subject to a knowledge qualifier, whereas the original capital commitment representation is typically flat. This result makes sense because it is difficult for the seller to argue that it does not know how much it originally committed to the fund. On the other hand, the seller’s capital account balance and remaining unfunded capital commitment are determined by the fund; thus representations regarding those two key facts are typically made to the knowledge of the seller based on information provided by the GP. The well-advised buyer will independently verify such amounts with the GP.

Buyers also assume the seller’s obligations under the fund’s governing documents. To ensure that it knows the dimensions of those obligations, the buyer typically requires the seller to list in a schedule each contract that it is assuming. Sellers often try to qualify this representation to their knowledge, but most buyers strongly resist this on the grounds that they cannot assume obligations under unspecified and unknown contracts.

Three legal representations are also worth noting:

      1. That the seller has good title to the interest it is selling. This is rarely controversial, but it is a critical underpinning of the PSA.
      2. A bilateral representation to the effect that one party may have access to information regarding the fund not available to the other party, and that the other party acknowledges this fact. This is particularly important when the buyer is not an existing LP of the fund, or when the buyer is an LP of the fund with a much larger commitment than the seller and perhaps a seat on the Limited Partner Advisory
      3. To confirm that the buyer does not have a regulatory profile that would be a poor fit for the interest in question. For example, if the buyer is a benefit plan investor, this could cause problems for a fund that is avoiding plan assets status by keeping participation by benefit plan investors under 25 percent of commitments. Alternatively, if the buyer is a taxable US investor, it may not be a good candidate to buy an interest in a feeder that is classified as a corporation for US tax purposes.

Although one might expect these issues to be vetted during commercial due diligence, it is surprising how often they are first raised when negotiating the legal representations in the PSA.

Excluded obligations

As noted above, the buyer typically assumes all of the seller’s obligations under the fund documents governing the interest, including the seller’s remaining capital commitment  to the fund. However, the buyer does not assume all of the seller’s obligations. For that reason, one of the critical legal issues in secondaries transactions is defining the scope of the seller’s obligations that the buyer does not assume (generally referred to as ‘excluded obligations’).

Excluded obligations generally consist of the following items:

  • Pre-closing breaches by the seller of the fund’s governing documents.
  • The seller’s pre-closing and closing tax obligations.
  • Losses caused by the seller’s pre-closing acts and omissions.
  • Obligations related to portfolio companies, which are realised on or before the closing.

Each of these items is discussed below.

Excluding obligations resulting from the seller’s pre-closing breaches of the fund’s governing documents is relatively uncontroversial. For example, if the seller’s representations under its fund subscription agreement were false and resulted in a loss to the fund, most sellers and buyers agree that the seller would retain this obligation  and it would not be assumed by the buyer. Sellers must be careful that this exclusion is limited to pre-closing obligations under the fund’s governing documents and not under the PSA itself. Breaches of the PSA are governed by the PSA and its indemnification regime, and should not be treated as excluded obligations that the buyer does not assume.

Similarly, excluding the seller’s closing and pre-closing tax obligations is rarely controversial. Any claims by the fund for taxes that should have been withheld on a pre-closing obligation, or taxes associated with the sale of the interest, are generally acknowledged to be obligations retained by the seller. This item has become more significant since the issuance of the new partnership tax audit rules,¹ and buyers should be careful to ensure that the PSA properly takes into account the new fund-level adjustments permitted under those rules, and allocates such liabilities to the seller.

The third item listed above is also uncontroversial. Losses resulting from the seller’s acts or omissions are typically retained by the seller. For example, if the seller has provided a post-closing certification to the fund regarding its regulatory status (for example, for purposes of the ‘bad actor’ rules under Rule 506(d) promulgated under the Securities Act) which proved to be false, the liabilities associated with that action would rarely be assumed by the buyer. Occasionally, buyers try to expand this exclusion to cover any pre-closing acts or omissions, regardless of whether they were connected to the seller. Most sellers reject this approach on the grounds that general risks associated with the fund (for example, one of the fund’s portfolio companies experienced setbacks which were not reflected in the fund’s valuation of that portfolio company) must be assumed by the buyer.

The fourth item listed above is one of the most contentious issues when negotiating a PSA. Some buyers take the position that any post-closing losses associated with portfolio companies realised by the fund before the closing should be borne by the seller, regardless of whether that loss is recovered by requiring partners to return distributions made with respect to such portfolio companies through calling down additional capital contributions, or by funding such loss through the fund’s other assets. Sellers typically resist this position because it is difficult to implement and it can significantly delay closure on a transaction. Under the most pro-buyer version of this position, the seller would be responsible for any post-closing loss on a realised deal, even if the fund financed the loss in question from its own assets and did not directly involve the partners. Such a loss could occur at any time, and the buyer and seller would have little visibility into the amount of the loss and how it was allocated among the various LPs and the GP.²

Sellers, on the other hand, argue that these types of risks are incorporated  into  the fund’s NAV and should therefore be assumed by the buyer. A typical compromise is for the seller to remain responsible for any distributions recalled by the fund pursuant to a partner giveback provision, because the seller’s share of such liabilities is easy to identify and limited in duration (as giveback provisions can often be invoked only two to three years after the date of a distribution). Sellers should be careful to remain responsible only for givebacks of distributions on or before the reference date (as opposed to the closing date), because the buyer typically receives the economic benefit of all distributions after the reference date.

Closing conditions

While the buyer and seller may occasionally arrange to ‘sign and close’ on the same day, the actual transfer of the interest occurs several days after the PSA is executed. As such, the buyer and seller agree in advance that certain conditions, listed below, must be met prior to closing:

  • GP consent. Most importantly, as noted above, the GP must consent to the transfer of the interest and the admission of the buyer as a new As previously noted, this is accomplished through a transfer agreement, which typically provides that the buyer agrees to assume all the seller’s obligations and be bound by the fund’s subscription documents and limited partnership agreement. Most GPs resist significant changes to their form transfer agreements, and the buyer and seller have little leverage if they want the transfer to be approved. The GP usually requires that:
    • the buyer and seller agree to indemnify it for damages resulting from the transfer;
    • the buyer and seller pay all expenses incurred by the GP’s counsel in processing the transfer; and
    • the transfer occurs at the end of the fund’s fiscal quarter (or at a minimum, month end).
  • Multiple Interest Transfers. While this chapter has focused on single interest sales, additional issues arise in instances of sales of an entire portfolio of interests. If the portfolio consists of a large number of interests, it becomes quite difficult to arrange for the transfer of all interests on a single closing date. Not only is it more administratively burdensome, but certain funds may have their own particular requirements for transfer (for example, as discussed above, a right of first refusal or ‘publicly traded partnership’ issues at the fund level). The buyer or seller (or both) may only be interested in pursuinga transaction if a significant portion of the portfolio will be transferred successfully. In such cases, it is not uncommon for the PSA to require a certain percentage (typically at least 50 percent by NAV) of the interests to be transferred on the initial closing date.   If the buyer and seller are not able to achieve such a minimum threshold, either party may call off the transfer of all interests.
  • No Material Adverse Effect (MAE) condition. Experienced M&A practitioners will be surprised to learn that, despite the fact that there can be a considerable delay between executing a PSA and closing the underlying transaction, PSAs for secondaries transactions do not contain a MAE clause. Increases and decreases in the value of the interest between the date of the PSA and the closing date are for the account of the buyer. Given the limited ability of LPs to influence the operations of a partnership,  this makes sense compared to a traditional operating company in an M&A deal. In addition, the PSA contains post-closing covenants limiting the seller’s ability to take certain actions with respect to the interest without the buyer’s consent. The lack of an MAE clause signals that most buyers and sellers regard the economic ownership of the interest to have transferred following the execution of the PSA.


Perhaps tied with excluded obligations as the most hotly contested issue in PSAs is the indemnification provision. While the limits on indemnification are symmetrical between the buyer and seller, in reality it is the limits on the seller’s indemnification obligations that are really at stake. This is because it is unusual for the seller to have any significant claims against the buyer under the PSA.

This friction first appears in the ‘Survival’ section in the PSA. This section limits the ability of either party to bring claims for the breach of representations and warranties after the expiration of the survival period. Although the limitation applies equally to the buyer and seller, the seller will push for a shorter survival period with the buyer pushing for a longer survival period. For  the majority of  representations, the buyer and seller tend to agree  to an 18-month survival period. However, certain ‘fundamental representations’, including due authority to enter into the PSA and consummate the transaction and, with respect to the seller, title to the interest, survive until the fund’s dissolution.

The economic limitations on indemnification come in two forms: a minimum threshold  for claims and an overall cap on damages. To avoid controversy over relatively de minimis claims, the PSA usually provides that no party shall be required to provide indemnification until such claims exceed an agreed threshold (typically based on a percentage of the purchase price). As the seller is less likely to bring a claim, it prefers a higher threshold than the buyer. While it varies, between 1 percent and 2 percent of the purchase price is generally considered a ‘market’ threshold level. In addition, the buyer will want to be sure that once the threshold is exceeded, it can recover from ‘dollar one’, as opposed to just amounts in excess of the threshold.

In addition to the threshold, indemnification is limited by setting a cap on damages. Unlike traditional M&A deals, it is typical for damages in a secondaries transaction to be capped at 100 percent of the purchase price. The main point of negotiation is whether the purchase price is defined as the cash transferred at closing or whether it also includes the liability assumed by the buyer, specifically the seller’s remaining unfunded capital commitment. The buyer will argue that the seller’s remaining unfunded capital commitment should be included because it is a critical part of the consideration received by the seller — the buyer has to make a cash payment to the seller at the closing and make capital contributions to the fund. In most cases, sellers are able to resist the inclusion of the remaining unfunded commitment in the cap. However, a seller with less negotiating power may be willing to permit the cap to include capital contributions actually made by the buyer to the fund during the buyer’s ownership of the interest (as it is not uncommon for a fund to dissolve with some amount of capital commitments remaining unfunded). In multiple interest deals, sellers often try to impose this cap on an interest-by-interest basis rather than in the aggregate, a position (not surprisingly) fiercely resisted by buyers.

While a technical point that is easy to overlook, buyers should be sure to confirm that the indemnification cap only applies to breaches of non-fundamental representations and warranties (as opposed to all claims under the PSA). Liabilities arising due to fraud, excluded obligations, breaches of covenants, and breaches of the aforementioned fundamental representations and warranties, are typically not capped.

In addition to the above, sellers usually want the PSA to specify that indemnification is the sole remedy for breach of the PSA and that punitive and consequential damages are not available. The lack of a ‘remedies exclusive’ clause provides an effective end run around the cap on indemnification for the non-breaching party. In the current market environment, punitive and consequential damages are usually excluded unless awarded in the context of a third-party claim.

Allocation of expenses

The expenses of each party to the PSA are typically borne by that party. The expenses incurred by the fund in approving the transfer and negotiating the transfer agreement, however, are typically shared equally by the buyer and seller. The one exception to this rule is when the buyer wishes to enter into a side letter with the fund. In that case, the fund’s expenses incurred in connection with that side letter negotiation are typically borne only by the buyer. Most secondaries transactions today are intermediated by a broker, and the PSA needs to specify which of the two parties is responsible for the commission owed to the broker.

Specific performance

An important legal protection for the buyer in a PSA is the right to demand specific performance. The assets sold in secondaries transactions are relatively unique and a well-advised buyer will insist on the right to demand specific performance in the event the seller defaults on its contractual obligations. Many sellers are also requesting a reciprocal right to demand specific performance on the grounds that money damages are not an adequate remedy for the right to have the buyer assume the unfunded capital commitment associated with the interest in question.

Raj Marphatia is a partner, and Frank Williams is an associate, in the private investment funds group at Ropes & Gray LLP. They represent both sponsors and investors in private funds, and have extensive experience in both primary and secondaries transactions. With respect to secondaries transactions, they represent buyers, sellers, and intermediaries in a wide variety of transactions including traditional secondaries, structured secondaries, fund reorganisations, and fund recapitalisations.

¹Sections 6221 through 6242 of the US Internal Revenue Code of 1986, as amended by the Bipartisan Budget Act of 2015.

²Ironically, buyers who espouse this position rarely offer to share with the seller any post-closing gains or recoveries on a portfolio company that was realised pre-closing (for example, an earnout or a portfolio company that was written off but experienced a renaissance).