Tender offers have become increasingly common in secondaries purchases of private equity fund interests. They involve a potential buyer proposing to purchase up to a certain amount of the investments of the existing LPs of a fund, who usually have no redemption rights and no ability to exit their investments except through transfers to other parties. The process is either initiated by interested buyers, or by managers seeking to restructure their funds or provide liquidity opportunities to their investors.
While tender offers can provide existing investors with liquidity and GPs with new LPs, they involve unique challenges that may not be present in typical secondaries transactions.
Private equity fund managers initiating a tender offer play a much more active role than in classic transactions. For example, as part of the process, managers may engage brokers to conduct an auction and may handle negotiations with the highest bidder, with the aim of providing a pre-negotiated price and purchase agreement to existing investors. Some managers may be more engaged than others in negotiating and existing investors are often instructed that terms cannot be materially changed.
As a result, in determining whether to sell, some investors may be more accommodating or flexible on certain terms as they may assume that they were heavily negotiated; in other instances, investors may not realise that a GP has such an active role and may not appreciate the extent of its conflicts of interest.
A manager should therefore be transparent with investors and include proper risk factors and conflicts of interest disclosures in the tender offer documents. These should include the extent of a manager’s fiduciary duties to investors in the process and its role in selecting a buyer, approving the price and negotiating the terms of the offer.
Stapled secondaries and fund restructurings
Some tender offers are part of larger ‘stapled secondaries’ transactions, in which the manager agrees to the sale of interests in a prior fund in exchange for the buyer committing capital to a new fund.
While a manager may believe these transactions represent ‘win-win’ situations, as they provide liquidity opportunities and increase the capital commitments to the new fund, it nevertheless has a fiduciary duty to its existing investors that could be compromised by its role in the tender offer. For example, the GP may be incentivised to steer the offer to a particular buyer or negotiate terms that are less favourable to the seller to secure a commitment from a buyer for the new fund. In response to these concerns, the Securities and Exchange Commission has recently indicated that it intends to focus on stapled secondaries transactions in its compliance examinations.
Tender offers are also sometimes part of a restructuring of the entire fund, where investors are provided with the opportunity to sell their interests in a fund to a third party (often at a discount) or roll over their interests into a new vehicle with new terms. The SEC has recently expressed concern about this practice, as investors are being presented with choosing between two options that may be unattractive to them.
Managers should consider involving the fund’s advisory committee in the process to represent the interests of investors, especially when it is a part of a stapled secondaries or fund restructuring. Given the regulatory focus on these deal types, a GP should disclose to investors the same information that it provided to the bidder, the extent of its role in the tender process and any possible conflicts of interest.
Allocation of expenses
The costs relating to tender offers are potentially significant, due to the number of prospective bidders and sellers and the extent of legal work required. When a manager engages a broker, it may not have as much of an incentive as a seller to negotiate the amount of broker fees payable at closing, which may ultimately be borne by the participating investors. LPs that participate in a tender may be asked to bear the costs incurred in failed negotiations with non-participating investors. Managers should set expectations in the tender offer documents for the amount of fees and expenses and who will bear them, and LPs should request information on expenses incurred to date, rates of fees and how expenses are allocated.
Timing of transactions
Because of the many moving parts, it is often difficult to sign all purchase agreements and close on all transfers on the same date. Sellers that have agreed to the documents with the buyer may be asked to wait for a sufficient number of others to do the same before they sign, which introduces additional execution risk.
If a seller signs and closes on a transaction before other participants, it may also be asked by the manager to bear a greater amount of expenses, as the GP has an incentive to recoup costs as quickly as possible, even if that means that expenses are not allocated pro rata among all participating sellers.
Typically, a prospective buyer offers to purchase interests from all of the existing investors in a fund, who may have different legal, tax or regulatory circumstances. Some of them may have opted out or been excused from certain investments, elected to participate in certain structures for tax reasons or waived certain rights for regulatory purposes. The prospective buyer should attempt to perform due diligence on these issues before making the offer and may need to structure the transaction so that it limits the impact of these investor-specific circumstances.
Source: The authors.
Baseline pricing considerations
Investors that receive tender offers gain useful information on the possible pricing of their otherwise hard-to-value illiquid investments. They also benefit from not having to undertake their own auction process to determine whether it is worthwhile to sell their investments. This information may enable an LP to sell its interest outside the tender offer process for a higher price or for more favourable terms. Prospective buyers should be aware that their bids may be shopped around and that they may face competitive pressures from other interested purchasers.
Lack of appetite
Potential buyers sometimes go through the tender offer process and find that they are unable to purchase their desired investment amount. In a stapled secondaries transaction, where the buyer is making a primary investment in a new fund in exchange for a tender offer of interests in a prior fund, this inability to purchase the desired amount in the transaction may result in the buyer being unable to fully capitalise on its rationale for the entire deal or it may result in a reduced primary commitment. Given the time, cost and effort, buyers and managers should try to gauge the appetite of existing investors to sell their interests prior to initiating a tender offer process.
Lack of control by the seller
Because tender offers are either initiated by the fund manager or the buyer, sellers often lack the same level of control and leverage that they would normally have in a traditional transaction. Sellers often do not select the brokers, do not run the auction process, do not draft the initial documents and may have a limited ability to negotiate or control costs. Also, the presence of other potential sellers weakens any individual seller’s bargaining power.
Control of the fund by the buyer
There may be certain business and operational considerations for a fund manager as a result of a buyer purchasing a controlling stake of the fund. With tender offers, the ownership of the fund may end up being concentrated in a few limited partners. This magnifies the impact of a default by a buyer on the fund and its operations. Fund managers should carefully perform due diligence on whether the buyer is creditworthy and has sufficient assets to satisfy capital calls.
An investor that buys a majority of the interests in a private equity fund may be able to approve amendments without the consent of other LPs and, if it controls a supermajority vote, it may be able to unilaterally exercise certain rights. This may make the approval of some actions or amendments more efficient and therefore more attractive to the fund manager. But in other situations, such as removal rights, neither the GP nor other LPs may want the buyer to have this much control over the fund, in which case they may consider proposing amendments to the governance or operational controls of the fund to dilute the buyer’s ability to act without the consent of other investors.
In addition to legal issues common to all secondary transactions, buyers making tender offers should consider whether any requirements must be satisfied under the US Hart-Scott-Rodino Antitrust Improvements Act by virtue of buying a significant stake in the fund. If there is a concentration of ownership in the fund, the GP should also consider whether this would cause any issues for the fund’s reliance on relevant exemptions from laws and regulations which rely on certain investors in the fund owning less than a particular percentage of the fund, such as the US Employee Retirement Income Security Act of 1974 and Federal Communications Commission regulations.
An investor should consider requesting that the fund’s advisory committee be involved in any tender offer or similar process. This may serve to mitigate the conflicts of interest faced by a manager, ensure that the interests of LPs are properly represented and allow for reasonable and transparent procedures to be implemented. Both sides should also consider whether the advisory committee should be involved in approving decisions such as selection of the broker, the fees payable to the broker, the selection of the buyer and price, approval of the tender offer notice and transactional documents and the proper expense allocation among the investors.
Jedd Wider is the co-head of the global hedge fund practice and one of the leaders of the global secondary funds practice at Morgan, Lewis & Bockius and Joseph Zargari is an investment management associate focusing on secondary funds transactions at Morgan, Lewis & Bockius. This article does not represent legal advice or the views or opinions of Morgan, Lewis & Bockius.