The SEC’s plans for the GP-led secondaries market broken down

The US regulator's proposals cover single-asset secondaries deals, strip sales, full fund restructurings and multi-asset continuation fund deals, among others.

Last week, the US Securities and Exchange Commission voted to put new rules governing private fund advisers out for a 60-day period of public comment.

The regulations would, if implemented in their present form, have implications for the GP-led secondaries market.

Note that the term ‘adviser’, as used by the SEC, refers to fund sponsors.

Which types of deals will the rules apply to?

The rules will be applied to deals where a sponsor offers LPs the “option to sell their interests in the private fund, or to exchange them for new interests in another vehicle” managed by the sponsor. This includes:

  • Single-asset secondaries deals
  • Strip sales, where a fund sells a piece of multiple assets to another vehicle advised by the same sponsor
  • Full fund restructurings or multi-asset continuation fund deals

Although they do not strictly match the definition, the rules would also apply to tender offers, described as deals in which “an adviser may arrange for one or more new investors to purchase fund interests directly from the existing investors”.

It is not considered “adviser-led” for the sponsor to assist an LP in selling an interest in its fund.

Need for fairness opinion in GP-led deals

Sponsors will be required to obtain a fairness opinion to ensure the price on GP-led deals falls within a “range of reasonableness”, the SEC has proposed.

“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,” it added.

The main potential conflict it highlighted is when a sponsor has the opportunity to earn “economic and other benefits” conditioned upon the closing of the secondary transaction, such as additional management fees or carried interest, it wrote.

“We understand that certain advisers obtain fairness opinions as a matter of best practice… To the extent that this practice is not universal, the proposed rule would mandate it in connection with all adviser-led secondary transactions,” SEC concluded.

Independence of fairness opinion provider must be made clear

The sponsor will also have to distribute to investors “a summary of any material business relationships” that it or any related person has or has had with the fairness opinion provider in the past two years. These include but are not limited to matters related to:

  • audit
  • consulting
  • capital raising
  • investment banking

The provider must give fairness opinions “in the ordinary course of its business”, meaning it has expertise in valuing illiquid and esoteric assets. The provider must not be a “related person” of the fund sponsor, to reduce the risk of a biased opinion.

The SEC acknowledges that it is difficult to define what “related” means: “An opinion provider that receives an income stream from an adviser for performing services unrelated to the issuance of the opinion might not want to jeopardise its business relationship with the adviser by alerting the private fund investors that the price being offered is unfair,” it noted by way of example.

By disclosing all potential conflicts, it gives limited partners the chance to judge for themselves whether a relationship could result in a biased opinion, it concludes.

Joel Wattenbarger, co-head of law firm Ropes & Gray’s private funds regulatory practice, told Secondaries Investor he did not expect the SEC’s proposals would fundamentally change the attractiveness of the secondaries market or GP-led secondaries deals.

“Sponsors already regularly obtain fairness opinions as a means of addressing conflicts of interest in GP-led secondary transactions,” Wattenbarger said. “As a result, I don’t expect the proposed rule to fundamentally alter the market dynamics for these transactions.”

However, the details of the proposed rule are likely to create some additional complexity and expense for sponsors relative to current market practice, he added.

Questions for secondaries buyers

Among a long list of questions that the SEC presents for consideration are:

  • Do commenters agree with the scope of the proposed rule? Should the rule apply to all investment advisers? Why or why not?
  • Should certain adviser-led transactions be exempt from the proposed rule? For example, if the adviser uses a competitive sale process to come up with a price, should advisers still be required to obtain a fairness opinion?
  • Do competitive bids typically represent net asset value? Does net asset value always correspond to the current value of the assets being sold? Why or why not?
  • Should the SEC require the fairness opinion to cover the terms of the transaction, as well as just the price?

The full document can be found here.

– Michael Baruch contributed to this report