A growing market
The secondary market for fund interests has grown tremendously over the past few years. In 2014, Cogent Partners estimated that secondaries volume for the year reached $42bn, representing more than three-fold growth over a five-year period from 2009 to 2014.
Secondaries transactions are becoming more sophisticated and innovative as the secondary market continues to offer viable solutions for GPs and LPs seeking end-of-life solutions for funds. According to an in-depth survey of the secondary market conducted by Prequin in February 2014, 65% of managers of secondaries funds surveyed indicated that they had purchased interests in buyout funds in 2014, and a third of respondents expect to spend more on purchasing buyout funds in 2015 than in 2014.
For those LPs which have not explored this market opportunity yet, it generally involves the following process:
Obviously the first step is finding a willing buyer or seller. The growing number of buyers and sellers involved in the market, and the complexity of transactions, has created opportunities for intermediaries, and 61% of respondents to a recent Prequin survey indicated that 50% or more of the transactions they completed involved an intermediary on the buy side, the sell side or both. Traditionally, these firms represent sellers by approaching multiple buyers to generate competition for the interests in question. However, intermediaries are increasingly acting for buyers as well.
The purchase agreement
The buyer and seller will then enter into a sale and purchase agreement (SPA), with a focus on high-level warranties relating to the fund interests being sold and getting the economics of the transaction right (particularly where LP clawbacks may be involved). The buyer will typically take the economic benefit and risk of the investment as of the date on which the latest NAV information was made available (and on which its bid was made). Given the seller’s role as a passive investor in the underlying fund, the SPA is typically much more simple than those used on a normal corporate transaction.
Consents and pre-emption
The SPA will typically provide for a split exchange and completion, given that the seller will need to obtain the consent of the relevant funds’ GPs and/or managers to the transfers, as well as fulfilling any other requirements stipulated in the underlying fund documentation. Although relatively unusual, some fund documentation may require the GP to offer the sale interests to existing LPs through a pre-emption procedure (a right of first refusal, or ROFR) before the third party transaction can go ahead.
Although the documentation to complete the transfer – typically transfer deeds, a deed of adherence signed by the buyer, and the GP consent – are relatively straightforward, there is usually some element of tri-party negotiations of the transfer documentation between the purchaser, seller and GP, so the GP should be involved early on in the process. The buyer may also want to negotiate a side letter with the GP before the transaction can complete (to take the benefit of an existing side letter the seller may have, or to add certain requirements of its own).
If the fund is a UK-based limited partnership, the sale will only be completed from a legal perspective once the GP has filed a notice of it in the Gazette.
Some issues which may be a trap for those without experience in secondary transactions are:
- Due diligence on underlying fund interests: This is likely to require more focus from a financial perspective than on an initial investment as transfers will usually occur once the fund’s investment period has terminated, when all or a significant portion of its investments have already been made. The focus therefore shifts from the manager’s past performance to the actual performance of the fund and its investments.
- Multiple interests: If the transaction involves the sale of multiple fund interests between the same seller and buyer, the SPA(s) should take into consideration the outcome of the overall transaction in the event one or more sales cannot complete (e.g. where GP consent is withheld on a transfer).
- Transaction volumes: The fund documentation may contain various restrictions, which the GP may be required to consider prior to consenting to a transfer; for example, specific restrictions relating to volume of transfers in a given year, such as breach of the U.S. Publicly Traded Partnership rules. The volume of transactions at the moment may cause issues here which have not been encountered in the past. Involving the GP in the process early on can help to mitigate last minute issues like this.
- Rights of first refusal: If the underlying fund documentation provides for a right of first refusal, the seller will need to consider, in light of the specific restrictions, whether to launch the ROFR process before or after the SPA is signed, and confirm with the GP exactly what the process is. The seller may also want any key protections in the SPA to be reflected in the transfer documents which will be signed by an existing LP which successfully bids for the interest under the ROFR, as this process will typically be run by the GP without a bilateral SPA.