November 2, 2022 – GP-led secondary transactions enable a sponsor or general partner (GP) to manage one or more existing assets in a newly formed fund capitalized by new investors through a fund restructuring. These transactions are often proffered as a win-win-win — for GPs, investors and buyers — but as the market continues to expand against a backdrop of increased regulatory scrutiny, navigating the conflicts of interests has become increasingly important. This article explores key considerations in managing conflicts of interests in GP-led transactions.
GP-led transactions present an inherent conflict of interest due to the GP’s position as both seller and buyer. The GP acts as seller by virtue of its role as sponsor and fiduciary to the existing fund selling assets to the new fund and acts as buyer by virtue of its role as sponsor and fiduciary to the new fund. The GP is also self-interested in the transaction as, in many instances the GP may be able to crystallize carried interest and “reset” economics (i.e., the cost basis for its carried interest on new investors). This reset can create an incentive for the GP to agree to a lower price. To further complicate the web of conflicts, GPs may offer co-investment or staple investment opportunities for other funds managed by the GP as part of the transaction.
One of the first steps a GP should take in mitigating conflicts is to survey the governing documents relevant to the existing fund, including the operating agreements, side letters, offering documents, other fund documents and underlying asset documents. These documents may contain provisions concerning restrictions, rights and obligations relevant to the transaction, including clawback obligations, consent requirements, rights of first refusal and tag and drag rights. Legal diligence of the fund documents can also unveil whether amendments will be required and provide guidance on the voting requirements for the limited partner advisory committee (LPAC).
An important role of the LPAC in any private fund is to advise on conflicts for related-party transactions. As such, another important early step in managing conflicts is engaging the LPAC to ultimately obtain its waiver of any conflict. Many GPs approach the LPAC for informal approval in the early stages of exploring a transaction before the sale process is actually initiated and then obtain formal approval once bids from prospective buyers are received.
Certain LPAC members may need to recuse themselves from the formal approval if their institution intends to participate as a prospective buyer. While the LPAC is not charged with approving the terms or price of the transaction, full and fair disclosure of all material terms of the transaction and potential conflicts of interests is essential. The LPAC will want to understand why the proposed transaction is the best option for existing investors and what price discovery methods the GP intends to employ. In some instances, the LPAC may request a fairness opinion or third-party valuation.
A fairness opinion is produced by an independent opinion provider or valuation agent and opines on whether the price being offered is within a fair range. Typically, the opinion is accompanied by a valuation report focused on pricing the target assets. While fairness opinions are used to help mitigate conflicts of interest, they do not necessarily ensure the highest price and other price legitimization tools exist.
Another mechanism for providing comfort on pricing is inherent in the sale process itself. In a competitive sale process, the transaction price is determined through a bidding process typically run by a third-party advisor. The bidding prospective buyers will independently diligence the sale portfolio to determine what value they attribute to the asset and how much they are willing to pay to win the bid. This auction process can present the GP with multiple offers and as such is another helpful price discovery tool.
Recently, some GPs have coupled the GP-led auction process with a minority direct sale to a third party. If the GP ran a direct sale process to no avail or the price offered in connection with the GP-led sale process is better, these facts also help mitigate concerns around conflicts of interest with respect to price.
Transparency is a key component in risk-mitigation and ensuring the LPAC and existing investors have the information needed to make an informed decision. Disclosure documents should describe the rationale for the transaction, the alternatives considered, the risks of the transaction, the terms, the process for electing whether to sell or “roll” in the new fund vehicle and any other information pertinent to the investor’s decision.
The amount of time allotted to review the disclosure documents and make an election can be an area of concern for existing investors. GPs should consult the fund documents for guidance on how much time is required or sufficient to review the election materials, and how to deal with non-responsive investors. By forcing non-responsive investors to cash-out, they miss out on potential upside. By forcing non-responsive investors to roll, they extend their investment on potentially different terms.
GPs should also look to remain engaged with existing investors as market conditions change and can influence the decision-making process. Not only can changes in the market impact whether an investor determines to sell or roll into the new fund vehicle; the SEC has found that failing to disclose material changes in value can rise to a material omission in violation of the Investment Advisers Act. In its 2019 guidance, the Institutional Limited Partners Association (ILPA) recommended that the LPAC advise on the optimal frequency and means of disclosing information to existing investors.
Offering existing investors the opportunity to roll on the same economic terms and conditions as the existing fund (a “status quo” option) can also mitigate conflicts of interest. On one hand, if the GP permits investors to commit new capital to the new fund vehicle, this could dilute the investment of existing investors and reduce some of the benefit of a status quo option.
On the other hand, if the GP does not require the rolling investors to commit new capital, the new investors will have to contend with the issue of existing investors benefiting from the new capital committed without having to similarly contribute. However, a status quo option may not be appropriate in all transactions. If there is any differentiation between new investors’ and existing investors’ terms, GPs should ensure these differences are adequately disclosed in the election materials.
Economic alignment between the GP and new investors is also helpful in addressing conflicts. To address alignment in the new fund vehicle, a GP may (i) invest capital; (ii) roll carried interest from the existing fund into the new fund vehicle if the GP’s carried interest in the existing fund crystallizes as a result of the transaction; and (iii) incorporate sufficient hurdles and carried interest thresholds in the new fund’s waterfall (the method of distributing investment returns among investors).
GP-led transactions can also include a stapled-primary commitment component whereby the new investors agree to simultaneously make a commitment to the GP’s latest fund. To mitigate the conflict of interest, GPs should ensure adequate disclosure and may need to substantiate that the introduction of the staple commitment requirement did not result in a lower price through use of a fairness opinion or other mitigation tool.
In order to successfully navigate the conflicts of interest present in GP-led transactions, GPs must carefully consider the various mitigation tools available and tailor their approach based on the specific conflicts present.
Fadi Samman is a regular contributing columnist on investment funds for Reuters Legal News and Westlaw Today.
Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.