Why the SEC is worried about staples

Earlier this month an SEC official speaking at an industry conference signaled the US regulator’s interest in stapled secondary deals. Do they create situations where fiduciary duty may be skirted?

Stapled transactions are nothing new and represent only 5 to 8 percent of secondaries deals.

But they seem to be on the rise and these deals – which typically involve the buyer of a limited partner interest also making a commitment to the general partner’s new fund – have attracted the attention of the US Securities and Exchange Commission (SEC). And for good reason, according to several sources who spoke on condition of anonymity.

“It brings a set of risks that are probably not in the best interest of investors,” said a person familiar with the SEC’s concerns. “There’s something structurally wrong with stapled secondaries and it’s not the case with direct secondaries.”

The SEC declined to confirm whether or not it was officially investigating the practice. But market sources say the regulator’s concern relates to two points in particular.

First, there’s a worry that GPs seeking – or indeed, in some cases, demanding – staples as a part of any secondaries sale aren’t fulfilling their fiduciary duty, but are instead putting the interests of the firm (and raising the next fund) before that of existing limited partners.

“It’s problematic,” said one private equity market participant. “A GP putting restrictions on an LP is entirely selfish. The GP is putting its LPs at a disadvantage.”

The other concern is an extension of the first, and to do with whether a GP is as fully transparent as it can and should be with existing LPs when negotiating a stapled deal.

Secondaries buyers and advisors who recently gathered for PEI’s secondaries roundtable noted that staples must be evaluated carefully on a case-by-case basis by all parties.

Pantheon’s Rudy Scarpa noted his firm models out the impact of a staple, or unfunded commitment portion of a secondaries deal, “and it’s oftentimes dilutive to the overall returns of the secondary transaction.  However, going forward we’re going to see an increasing number of GPs seeking to manage their LP base more proactively. That includes controlling which LPs come into their funds on a secondary basis.”

The circumstances surrounding a stapled transaction can vary greatly. When part of a fund restructuring process – which the SEC has recently flagged as an area of interest – existing LPs are typically presented with several options ranging from accepting the offered price and walking away, to rolling their interest into a new fund under new terms while suffering dilution. If the secondaries buyer is putting in fresh capital, it clearly benefits the GP who now has more runway.

Staples can be a good thing if done right, sources stressed.

“Ideally, a stapled secondary should combine the highest price in the bid [spread] and a guaranteed continuity of LPs,” said another market participant. “Then everybody wins.”

What’s your view? As the new editor of Secondaries Investor, I’m keen to hear from as many of you as possible. Get in touch at marine.c@peimedia.com.