Private Equity Newsletter (Winter 2009)
- Secondary Investments in Interests in Private Equity Funds

A "Secondary Investment" in an interest in a private equity fund occurs when a buyer acquires all or a portion of an existing investor's (i.e., the "primary" investor's) interest in the fund.  In the most straightforward form of the transaction, the seller simply transfers all of its limited partnership rights and obligations in the fund to the buyer.  There are also a number of more complex forms of Secondary Investments, including (i) "stapled secondaries," which occur when a buyer's secondary investment in an existing fund is linked to a primary investment in a new fund; (ii) "structured joint ventures," which include a wide range of possible customized, and often complex, arrangements between the seller and the buyer and (iii) a variety of other sophisticated arrangements.  This article focuses on the straightforward form of the transaction, although the principles discussed in this article generally also apply to the more complex forms of the transaction.

Economic Context

As the financial crisis has deepened, many private equity investors (like nearly everyone else) have experienced  a sharp decline in their overall net worth.  This decrease in net worth in many cases has also led to a decrease in available cash, which has led some investors to grow concerned about funding un-drawn capital commitments that they have made to private equity funds.  Moreover, the so-called "denominator effect" has caused many institutional  investors with strict limits on their asset class allocations to seek a rebalancing of their investment portfolios.  The "denominator effect" occurs when the value of the investor's overall portfolio (i.e., the "denominator")  has decreased, but the portion allocated to private equity investments (i.e., the "numerator") has not decreased (which is often the case with private equity funds, because they are valued infrequently).  As a result, the private equity investment becomes a larger portion of the overall portfolio.  For these reasons, among others, there is already evidence that more and more sellers of secondary interests in private equity funds are entering the market.  To the extent that the financial crisis continues, it is likely that the pace of the attempted sales will increase, especially as 2008 year-end fund valuations become available. Further, it appears that there are many investors interested in acquiring Secondary Investments, particularly if those investments can be purchased at low valuations or if they are in highly sought-after funds.  Accordingly, it seems that there is likely to be an active market for Secondary Investments in 2009.

Negotiation Points in the Purchase and Sale of Secondary Investments

In any sale of Secondary Interests, there are three primary parties:  the seller, the buyer and the fund's general partner.  The parties will generally document the transaction in two agreements:  (i) a purchase and sale agreement solely between the buyer and seller containing the terms of the transaction that do not involve the fund (such as the sales price, certain indemnities solely between the buyer and seller, etc.) and (ii) a transfer agreement among the general partner, the buyer and the seller.  While the general partner will typically have the most negotiating power in the transaction (because ultimately its consent will virtually always be required for the transfer), each party has its own particular interests regarding the transaction, as summarized below.

The seller's main goals generally include:

• Maximizing the amount that it receives for its interest.  This is a business point negotiated between the seller and buyer, and ultimately set forth in the purchase and sale agreement.  The purchase price will generally be based on the net asset value of the fund on a certain cut-off date, with closing adjustments for capital contributions made or distributions received by the seller after the cut-off date.¹  
  
• Minimizing its continuing liabilities to the fund.  The seller will usually want the buyer to provide a full indemnity for all liabilities (including the obligation to make capital contributions) that arise after the transfer of the interest.  The seller will also want to be released from all obligations to the fund (save, perhaps, certain clawback, confidentiality and indemnity obligations) after the transfer.
  
• Confidentiality.  Because of the possible stigma associated with a sale of a Secondary Investment, sellers often want to ensure the confidentiality of the transaction.  Accordingly, they will often want a non-disclosure clause in the purchase and sale agreement. 

The buyer's main goals generally include:

• Paying a fair price.  The buyer will typically do its own research regarding a fair price for the Secondary Interest.  Buyers, in determining the value of the investment to them, will often also focus on the perceived yield of the investment, how the investment will lead to a diversification of the buyer's portfolio (in asset class, vintage, etc.) and J curve reduction. 
  
• Assuming all of seller's rights, with no additional obligations. The buyer will want the seller to provide a full indemnity for any fund obligations that arose before the transfer (including the seller's obligation to return to the fund any distributions that it may have received in connection with any future limited partner "clawback").  The buyer should make sure that the transfer agreement specifically provides that it will become a "Substitute Limited Partner" (or the equivalent defined term from the operative fund documents), so that it has full economic and voting rights in the fund.  The buyer will usually also request that the transfer agreement state that the buyer will benefit from all terms of any side letter between the seller and the fund. 
  
• Receiving adequate representations from seller.  The buyer will want the purchase and sale agreement and the transfer agreement to include representations and warranties that the seller (i) is not currently and has not in the past been in default under any of the fund documents, (ii) has not waived any of its rights under the fund documents and (iii) has good and valid title to the interest being transferred.  Obtaining these assurances is important, because the buyer is stepping into the seller's shoes and needs to be confident that the seller has not forfeited any of its rights in the fund.  The buyer would like to receive these assurances from the general partner as well as the seller.  Many general partners may not be willing to provide any of these assurances, but some may be willing to negotiate limited compromise language on these points.  It is worthwhile, therefore, for the buyer to request those representations and warranties from the general partner.
  
• Obtaining a termination option in the event of a "material adverse change."  More and more buyers are requiring that the purchase and sale agreement contain a provision that allows the buyer to terminate the deal in the event that there is a "material adverse change" in the fund before the transfer has taken place.

The general partner's main goals generally include:

• Assurances regarding regulatory and tax matters.  The general partner's primary goal will be to make sure that the transfer does not adversely affect the Fund, the other limited partners or the general partner itself.   The general partner's concerns will include whether the transfer will subject the fund or the general partner to administrative, tax or regulatory burdens, such as those potentially arising out of issues related to (i) ERISA plan asset matters; (ii) federal income tax consequences to the partnership and its partners; (iii) blue sky requirements; (iv) Investment Company Act compliance and (v) FOIA/state public records act matters.  As a result, the general partner will want assurances that admitting the buyer will not subject the fund to any new ERISA, tax, securities, regulatory or FOIA issues.  Most commonly, the general partner will expect direct contractual assurances from the buyer that the transfer will not raise any of these matters.  However, some securities issues may involve the need for the seller to make certain assurances and some partnership issues may require the general partner's own analysis.  Further, some general partners will require certain legal opinions (such as tax opinions) as part of the transaction.  
  
• Confidentiality.  The general partner will typically want to maintain the confidentiality of the fund's financial information.  The seller should not provide the potential buyer with such information without first reviewing the operative confidentiality language in the fund documents, and if necessary, requesting the general partner's consent to sharing such information. The general partner is likely to require the potential buyer of the Secondary Investment to sign a confidentiality agreement before it gains access to the fund's financial information for its due diligence.  
  
• Indemnification.  The general partner will also want to ensure that neither the fund nor the general partner gets entangled in disputes between the buyer and the seller.  Therefore, the general partner will want the transfer agreement to provide that the fund, the general partner and their affiliates will have no liability for any losses related to the transfer (including any liability for failure to make appropriate disclosures about the financial status of the fund), and that both seller and buyer indemnify it against any such losses.  In some cases, the general partner will want the seller and the buyer to be jointly and severally liable for breaches of each other's representations and warranties in the transfer agreement (both seller and buyer will generally strongly oppose any such provision).
  
• Receiving adequate representations from both seller and buyer.  The general partner will want the seller to represent and warrant that it holds its interest free and clear of all liens and that it has not defaulted under the fund documents.  The general partner will also want the buyer to make the same types of representations that are normally present in subscription applications.  The general partner will generally require both buyer and seller to covenant and represent that they have not acted as a finder or broker with respect to the transfer and that they each did their own independent review of the transfer transaction.
  
• Fees and costs.  The general partner will want the seller and buyer to agree in the transfer agreement to be jointly and severally liable for all of the general partner's expenses related to the transaction.

Conclusion

The discussion above is a summary of some of the important considerations that a buyer, seller and general partner will take into account in a Secondary Investment transaction.  Of course, actual negotiations can often be quite complex, and all parties should seek the advice of consultants, accountants, attorneys or other service providers as appropriate. 

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¹ Cogent Partners reports that the simple average high bid for secondaries in all types of private equity funds fell from 84.7% of net asset value in the first half of 2008 to 61% of net asset value during the second half of 2008 (through November), which decrease it notes is in line with the concurrent decline in the value of public equities.  Colin McGrady, CFA and Brad Heffern, Cogent Partners, Secondary Pricing Analysis Interim Update, Winter 2008.

If you have questions about any of the issues raised in this article, contact Ellen Kaye Fleishhacker 415.399.3079 or your usual Howard Rice attorney.