Igor Rozenblit, founder, managing partner, Iron Road Partners

The secondaries sub-asset class came under the spotlight in new rules issued by the US Securities and Exchange Commission last year.

Within the private fund advisers rules under the Investment Advisers Act of 1940, which were voted through in the second half of last year, GPs either based in the US or with US investors must obtain a fairness opinion or a valuation opinion from a third party in continuation fund transactions.

That followed the requirement for registered private equity fund sponsors, which will have 60 days from the end of each quarter to report GP-led secondaries deals, the removal of a general partner, investor-led liquidations or other “termination events” under Form PF rules adopted by the US regulator.

With these new rules, Igor Rozenblit, managing partner and founder of governance, risk and regulatory services provider Iron Road Partners – who was formerly co-head of the private funds unit in the Division of Enforcement of the SEC – believes the regulator has sufficient tools to pursue the kind of conduct they want to put under the spotlight in these transactions. Here are the key points that can go wrong in GP-led transactions that the SEC has been trained to look for.

Nuances around valuation

While the SEC is usually concerned that valuations are too high in private markets funds, in GP-led secondaries transactions the regulator is worried valuations have been set too low and, as a result, have been artificially depressed, Rozenblit told Secondaries Investor.

Many LPs make a decision on whether to roll or sell in a GP-led transaction based on the percentage of net asset value they are receiving “and so the lower the value of your holding, the easier it is for you as the GP to tell your LP that you are transferring at 100 percent of NAV, or even more than 100 percent of NAV”, Rozenblit said.

“The SEC looks for a couple of red flags there. The biggest red flag is that an asset gets transferred from a fund into a continuation vehicle, and then it’s quickly thereafter written up or increased in value,” he added.

Companies’ undisclosed material facts

The SEC is “keenly aware” of undisclosed material facts about the portfolio companies being transferred in GP-led secondaries transactions, Rozenblit said.

The biggest point the regulator is searching for is good news that has been articulated to secondaries buyers and rolling investors, which hasn’t been relayed to selling investors.

“For example, if a portfolio company is very close to selling on selling or going public… the GP led transaction transfers that into a continuation vehicle, and then the company’s promptly sold, that’s a big red flag.”

Similarly, the SEC would be sceptical if a company that had not been performing well suddenly reverses its trajectory within the new vehicle, Rozenblit added.

Distribution of fees and expenses

A decade ago, the issue of GPs collecting economics in GP-led transactions was “somewhat of a big issue”, Rozenblit said. In those situations, the SEC “would try and act as quickly as possible”.

For the most part, the legal sector has “done a good job of disclosing the split of economics, which I think in [a] GP-led situation could be complicated and could really benefit the people rolling, as opposed to the people who choose to stay in the fund”, he added.

Notification and election processes

While it’s a tough area for the SEC to get its hands around, the regulator is aware of LP complaints around not being given enough time to evaluate some GP-led secondaries transactions, Rozenblit said. Some disclosures are also “written in a confusing way”.

If the SEC examiners are able to find evidence of those issues, “I think they would pursue those,” Rozenblit added.

Market cycles

The SEC also recognises that the GP-led market is cyclical and areas where conflicts of interests could be found can change over time, Rozenblit said.

Coming off the back of frothy markets, as we are today, the SEC will look to run the rule over GP-led deals where it is concerned that a lot of the companies involved in these transactions may have been able to fetch a better price via regular way M&A “and we just never know because there’s often not a non-GP-led auction in those situations”.

These transactions, which have historically been seen as “quote unquote good GP-led transactions” may have been used “almost as a way to deploy capital in a difficult market environment”, Rozenblit explained.

Rozenblit said he “wouldn’t be surprised” to see the SEC’s exam staff focusing more on this issue where these continuation funds “are just starting to… mature”.

In downturn markets, the SEC will be on the lookout for managers that are unable to raise additional capital who seek GP-led transactions to restart their fees in some way or entice new investors into a vehicle.

Those downturn market GP-led transactions may be on the SEC examiners’ horizons in the future – “they just are not mature enough for the SEC to start looking at them now”.

Rozenblit appears on the fifth episode of Secondaries Investor‘s Decade of Secondaries Investing podcast miniseries alongside Isabel Dische, chair of Ropes & Gray’s alternative asset opportunities group. The pair discuss the secondaries aspects of the private fund advisers rules under the Investment Advisers Act of 1940 and Form PF rules. Listen to the full episode here