The recent upheaval in the financial markets has not spared institutional investors in private equity funds. These institutional investors are increasingly expected to seek to liquidate interests in private equity funds in an effort to rebalance their assets and reduce their unfunded liabilities. Such activities are likely to result in a robust secondary market for private equity interests.
What is a Secondary?
Typically, investors in private equity funds acquire their interests directly from a fund, in a "primary" transaction. In a private equity "secondary" transaction, an existing investor in a fund seeks to sell the interest to a buyer, thereby creating a secondary market for that interest. Over the past several years, this market has grown tremendously and, for reasons discussed below, is expected to continue to grow at a rapid pace in the coming months as many investors look to reduce their private equity exposure.
Private equity fund investments, by their nature, are illiquid. State and federal securities laws and the fund's governing agreements typically impose significant restrictions on transfer. The life of a fund is typically 10 years or more, and investors do not have redemption, withdrawal or other rights to cash out their investment. Investors are obligated to contribute capital in installments over the life of the fund, and there are significant penalties for default on these contribution obligations. Secondary buyers, however, can, subject to the consent of the fund, offer liquidity for investors looking to sell an individual interest in a fund or a portfolio of fund interests.
The buyer in a secondary transaction assumes the obligations (including obligations to make capital contributions) of the seller under the fund's governing document (typically a limited partnership agreement), provides representations and warranties to the fund similar to those that would be included in a subscription agreement for a primary purchase of an interest, and seeks to obtain the benefits of any side letter or other special arrangement between the seller and the fund (such as the right to appoint an advisory committee member).
Why is the Market so Large and Growing?
In recent years, investors have had many reasons to sell, and secondary buyers have had many reasons to buy, private equity fund interests, sparking growth in the secondary market. Fund-of-funds focused on making secondary purchases have raised billions of dollars in capital over the past several years. Investors may be motivated to sell fund interests in order to generate cash, reduce private equity exposure, eliminate balance sheet liabilities associated with unfunded capital commitments, reallocate resources to funds of a newer vintage or with different sector focus, and limit the number of fund manager relationships and the associated administrative costs.
As a result of the recent market turmoil, it is anticipated that private equity secondary transactions will increase dramatically. Many investors have a heightened need for cash and a desire to decrease unfunded capital commitment liabilities on their balance sheets. Financial institutions, endowments and pension plans in particular may have high quality portfolios of private equity interests they want to sell.
Historically, as distributions from existing private equity investments declined, there has been a corresponding up-tick in secondary transaction activity. Due to low valuations and reduced merger and acquisition activity, it is expected that distributions from private equity funds will experience a sharp decline in the near term. As a result, investors may find that selling interests in some funds to provide cash for upcoming capital calls in other funds is the only viable option to avoid defaulting on commitments.
Buyers of private equity interests are highly motivated by the opportunity to purchase fund interests at historically low valuations. As discussed below, the purchase price paid for a private equity interest in a secondary is typically based on the fund's net asset value (NAV). Private equity funds determine their NAVs on a periodic basis (annually, semi-annually or quarterly). Markdowns in NAV resulting from the market downturn will be reflected on December 31, 2008 financial statements. Assuming market volatility settles by the first quarter of 2009, buyers may be excited at the prospect of purchasing fund interests at these low values. This desire to purchase may be enhanced by the fact that many secondary buyers may feel they overpaid for interests purchased in the last two years and will seek to "average down" their cost basis.
What are the Key Points of Negotiation in a Secondary?
There are three key sets of negotiations during a secondary transaction:
- initial purchase price for the portfolio of interests being sold;
- purchase and sale agreement between the buyer and seller; and
- transfer documentation among the buyer, seller and fund managers of the interests being sold.
The purchase price in a secondary transaction is usually based on the value of the interests being sold as of a set date, which is referred to as the cut off date. The cut off date is tied to the date of the most recent NAV calculations and the purchase price is driven by the NAV (it is either at par or at a discount or premium to NAV, depending on the buyer's valuation). At the closing of each transfer, the purchase price has a dollar-for-dollar adjustment for capital contributions made by the seller (increase in purchase price) and distributions received by the seller (decrease in purchase price) since the cut off date. Historically, prices have trended close to par with only a moderate discount or premium. Secondary buyers are expected to be particularly active in the first two quarters of 2009, basing purchase prices off the low December 31, 2008 NAVs.
It should be noted that although the economics are set as of the cut off date, timing considerations are important. For example, a buyer will typically prefer to receive a distribution shortly after closing, rather than getting a purchase price reduction so that the buyer can record the distribution as a gain on investment and include it in its internal rate of return computations.
Purchase and Sale Agreement
The definitive agreement for a secondary transaction is typically a purchase and sale agreement and resembles an asset purchase agreement used in a standard asset acquisition.
It has become increasingly common for purchase and sale agreements to include as a closing condition that no material adverse change (MAC) has occurred between signing and closing. These clauses have ranged from very broad coverage to more tailored provisions focusing on the departure of a particular manager. It is expected that MAC clauses will be more common, and more heavily negotiated in the next wave of transactions. Until recently, there had been no public reports that a buyer had invoked this clause and refused to close. In October 2008, it was reported that HarbourVest Partners backed out of a signed agreement to acquire private equity interests in reliance on a MAC condition. To date, the seller has not chosen to challenge the buyer's position, due to time constraints, so it is unlikely that this particular MAC clause will be interpreted by a court. Nonetheless, the buyer's ability to walk away from the transaction due to an alleged MAC provides another example of the recent increased negotiating power of buyers in secondary transactions.
In addition, there are certain negotiated terms that are specific to secondary transaction purchase and sale agreements, such as indemnification coverage for the buyer's obligation (referred to as a clawback) to return certain fund distributions, transfer of "threshold funds" and completion of "staple transactions."
Threshold funds are funds that must be transferred before the buyer will be required to close on any other funds in the portfolio. This focuses the attention in the transfer process on funds identified by the buyer as essential and provides the buyer with comfort that they will not be forced to buy only the less attractive interests in a portfolio. It is possible that sellers will soon seek to avail themselves of similar protections.
In a staple transaction, a fund manager requires that a secondary buyer commit to invest in a new fund sponsored by the same fund manager in order to obtain consent for the transfer of the interest in the existing fund. Buyers resist this provision because they do not want to be forced into making a primary investment. Although indications are that there will be more staple transactions, it is possible that as the supply of secondary transactions grows, buyers will have more leverage to avoid committing to new funds. Fund managers may want to accommodate transfers to reputable buyers, especially if there is a risk of default by the seller.
Unlike the purchase and sale agreement, the transfer process involves the fund manager, in addition to the buyer and the seller. The fund manager needs to determine if admission of the buyer will trigger regulatory or other issues for the fund itself.
In nearly all cases, the fund manager has the right to consent to a transfer of a seller's interest. In some cases, consent cannot be unreasonably withheld, but in others the determination is made in the fund manager's sole discretion. In addition, each fund may have other transfer restrictions that can slow down the process, including compliance with right of first refusal provisions, requirements that legal opinions be delivered and limitations on when interests can be transferred (such as a month-end or quarter-end) for accounting and administrative purposes.
The fund manager also needs to be certain that the transfer will not invalidate the fund's exemptions from registration as an investment company under the Investment Company Act of 1940. For example, a buyer and seller may be required to reduce the amount of interest transferred in order to ensure that a fund relying on the "100 or fewer" owner exception under the Investment Company Act will not lose its exemption.
Other legal considerations of concern to the buyer include limitations on the fund's ability to generate certain types of income (such as unrelated business taxable income (UBTI) and effectively connected income (ECI)); the fund's obligations to satisfy certain exemptions under the Employee Retirement Income Security Act (ERISA) (including whether the fund will qualify as a venture capital operating company (VCOC)); and the buyer's obligations to satisfy applicable anti-money laundering regulations.
Recently, fund managers have been expanding the indemnification coverage they expect in connection with transfers. Provisions include broad-based joint and several liability for breaches of representations and warranties and covenants in transfer agreements. Both buyers and sellers oppose these indemnification requirements. Because sellers want to remove all liability associated with a transferred interest from their books, they are frequently more vehemently opposed to these requirements.
As a practical matter, buyers and sellers have limited ability to negotiate the provisions of a transfer agreement, because ultimately the fund manager must consent to the transfer. Because all issues must be resolved to the satisfaction of the buyer, the seller and the fund, they can result in somewhat protracted discussions, which often lengthens the transferring process to three months or longer.
There are many indications that 2009 will be a boom year for secondary transactions. Financial institutions, endowments, pension funds and others will look to sell private equity interests to a growing set of dedicated buyers. As the marketplace grows and becomes more competitive, the legal and business landscape is also likely to change. It is important for both buyers and sellers to be prepared for the issues that will inevitably arise.