The GP-led secondary market is relatively new to Australia, but recent transactions show that the trend is here to stay. The confluence of instability in the global economy, often depressed M&A valuations and a lack of suitable IPOs have highlighted Continuation Funds as a way in which LPs can exit their investments at a respectable valuation whilst giving GPs the option of securing their most-prized assets by way of rolling them into a new special purpose vehicle.
Continuation Funds – sometimes known in the past as "GP-led restructurings" - also avoid the need for forced exits from Funds that have a fixed term, often between seven and ten years. Through the use of the scheme, managers can continue to manage the relevant assets irrespective of the life cycle of the Original Fund. The use of Continuation Funds also helps provide liquidity, which can be a vital consideration towards the end of a Fund's life in a challenging fundraising environment.
Yet the market is not without its challenges.
Since the GP is both the "seller", by virtue of being fiduciary and sponsor selling assets to the New Fund, and the "buyer" being fiduciary and sponsor of the Continuation Fund, there is an inherent conflict of interest. The GP has a particular interest in the transaction which may enable them to realise carried interest, which might incentivise the GP to accept a price lower than the LPs might otherwise be comfortable with.
In the United States, the Securities and Exchange Commission (SEC) has proposed a new rule that would oblige GPs to obtain a fairness opinion from an independent opinion provider "where an adviser offers Fund investors the option to sell their interests in the private fund, or to exchange them for new interest in another vehicle advised by the adviser. 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". 1
So how can GPs make the most of the opportunities whilst honouring their fiduciary duties and upholding their reputation? We outline five ways GPs can square the circle:
Be transparent
GPs will need to be able to clearly explain why the proposed structure represents the best way forward for Fund investors. The Fund Manager may have particular sector knowledge and relationships that would avoid the uncertainties and disruption of an M&A deal. The GP should be in a position to explain how it will apply the sale proceeds, thereby demonstrating confidence in the upside and driving value for the benefit of the selling investors.
Running a transparent process and providing plentiful disclosure enables LPs to take an informed view as to the benefits of extracting value or rolling their interest over into the new SPV. Enough time should be allowed in terms of proper due diligence, and the GP should be ready to answer questions promptly and fully.
Consider fee structure
Getting the fee structure right isn't just a matter of good business – it can be essential to getting the transaction over the line. The secondary buyer may expect a lower management fee or a lower carried interest rate which can be tiered based on performance. This will also be seen as fair for investors who choose to roll their interest over into the Continuation Fund rather than extract value there, and then by way of an exit.
Be advised
The use of LPACs (LP Advisory Committees) can be a bulwark for good governance when it comes to secondary transactions. Given that the GP has to observe fiduciary duties towards both the old and new Funds, an Advisory Committee, perhaps advised by an independent third-party valuer, can act as a valuable check.
The use of LPACs can also be a comfort to regulators who are often concerned that existing investors are being fairly treated and not railroaded into having to choose between two options, either of which may be for them less than ideal. The LPAC may be asked later down the track to approve conflicts that arise, so early communication with the LPAC is advisable.
Know the documents
The governing documents relevant to the Fund should be thoroughly reviewed alongside documents relating to the underlying asset. This can help alert buyers to restrictions, clawback provisions, requirements for consent, rights of refusal, etc.
Fairness opinion
Obtaining a fairness opinion from an independent third-party valuer will give confidence to all parties that the price being offered is fair. The opinion may be accompanied by a more detailed valuation report of the target assets. A fairness opinion can help assure investors that, in the words of the SEC, the price offered for the asset is based "on underlying valuation that falls within a range of reasonableness".
Hogan Lovells Private Equity team has global sector experience in advising GPs and LPs on how best to maximise potential and value from secondary transactions whilst ensuring that potential conflicts are addressed early on before they can cause problems.
- SEC Statement on Private Funds Advisors Proposal, Chair Gary Gensler, 9 February 2022 - https://www.sec.gov/news/statement/gensler-statement-private-fund-advisers-proposal-020922
Authored by James Wood and Nigel Sharman.
