The secondary market for private equity partnership interests has grown dramatically in both size and complexity over the last decade. The recent liquidity crunch and the turmoil in the financial markets are driving many institutional investors with stakes in private equity funds - including pension funds, university endowment funds, corporations and funds of funds - to seek to 'cash out'. Investors are seeking to liquidate some or all of their fund interests to reallocate their assets, gain liquidity, reduce contingent funding liabilities and manage key general partnership relationships.
Investors in private equity funds typically acquire their interest directly from a fund in a primary transaction by subscribing for partnership interests at the original launch of the fund. In a secondary transaction, an investor in a fund sells its interest in one or more funds to a third-party buyer at a negotiated price.
Secondary sales of private equity interests involve three sophisticated parties: the buyer, the seller and the fund itself. These transactions are usually subject to the consent of the fund manager or the general partner, due to various restrictions on the transfer of interests contained in the fund's governing documents. The buyer in a secondary transaction assumes the obligations (including capital call obligations) of the seller under the fund's partnership agreement and provides representations and warranties to the general partner that are substantially identical to the representations made by the original investor in a fund's subscription agreement.
Unlike the initial investors in a fund, secondary buyers are investing not just in the fund's management team and track record, but also in its existing portfolio companies. This provides the opportunity for careful due diligence and analysis of each of the fund's portfolio companies.
The purchase price is based on the value of interests being sold as of a particular date (the 'cut-off date'). The cut-off date is tied to the date of the most recent valuation of portfolio investments by the underlying fund. At the closing, the purchase price is usually adjusted for capital contributions made by the seller (an increase in the purchase price) and distributions received by the seller (a decrease in the purchase price) since the cut-off date.
Even though the price is based on a fund's portfolio valuations, particular timing considerations are important. For example, a buyer will often prefer to receive a distribution shortly after closing rather than obtain 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 calculations.
Purchase and sale agreement
One commonly negotiated provision is a material adverse change (MAC) clause, which permits a buyer to back out of the deal if the fund (principally its portfolio investments) undergoes material changes before the closing. These clauses range from very broad coverage to more tailored provisions. In the current environment, buyers may demand broad MAC clauses because of their concerns about the fund's performance before the deal closes.
Other important negotiated terms include:
- a clawback provision;
- the return of distributions by limited partners;
- the transfer of threshold funds; and
- completion of staple transactions.
A clawback provision in a partnership agreement requires the general partner to return distributions to the partnership under certain conditions. In addition, if a partnership makes wrongful distributions to limited partners, limited partners are required to return such distributions to the partnership. The general partner may insist that both buyer and seller be liable for such obligations. These issues are often addressed by the parties agreeing that the seller will repay the buyer (if wrongful distribution occurs), or the buyer will repay the seller (if clawback occurs).
Where a buyer is acquiring a portfolio of different fund interests from a seller, threshold funds are sometimes specified. These must be transferred before the buyer is required to close on the purchase of any other funds in the portfolio. This guarantees that the buyer will not be forced to buy only the less attractive interests in a portfolio.
In a staple transaction a general partner will seek to require 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 will often resist this provision because they do not want to be forced into making a primary investment.
Another commonly negotiated issue is indemnification. General partners request indemnification for breaches of representations, warranties and covenants in transfer agreements. Buyers and sellers typically seek to limit these indemnification requirements. In addition, general partners will typically seek indemnification with respect to future lawsuits claiming that they failed to make disclosures about the fund or its portfolio companies.
Transfer provisions in partnership agreements
A fund's limited partnership agreement typically requires the general partner's consent to the transfer of the fund's interests. Some agreements provide that the general partner's consent cannot be unreasonably withheld, while others leave the determination to the general partner's sole discretion. In addition, general partners will often screen new limited partners to ensure that they are able to satisfy future capital calls. Transfers to affiliates, subsidiaries and parent companies, and transfers between limited partners, are often carved out from the general partner's consent requirement.
Limited partnership agreements often require the delivery of a legal opinion by the transferor to the effect that the transfer:
- will not violate the Securities Act of 1933 (as amended) or any state 'blue-sky' laws;
- will not require the fund to register under the Investment Company Act of 1940 (as amended), or the general partner to be registered under the Investment Advisers Act of 1940 (as amended); and
- will comply with certain tax regulations as applicable to the fund.
Some agreements also require a notice of assignment within a certain period prior to the proposed transaction.
In order to execute a transfer, an instrument of assignment is usually required in a form satisfactory to the general partner, and the general partner typically has the right to request other documentation from the transferee. Furthermore, to become a substituted limited partner, the transferee must usually:
- execute a subscription agreement and any other documents requested by the general partner (eg, a counterpart to limited partnership agreement);
- pay any transfer expenses if requested; and
- be admitted as such by the general partner.
Limited partners often seek to modify transfer provisions in the limited partnership agreement via side letters. Side letters may include provisions requiring the general partner to consent to certain special transfers and:
- accept such transferees as substituted limited partners;
- waive the legal opinion requirement or other transfer restrictions; or
- agree to accept an in-house counsel's opinion.
Buyers typically seek to obtain the benefits of these and any other side letters to which the seller was a party.
Every transfer of limited partnership interests must comply with the fund's limited partnership agreement, federal and state securities laws and any other applicable regulations. The parties must ensure that a secondary sale does not alter the fund's tax status and the fund's and other parties' reliance on exemptions from the registration requirements under the Securities Act, the Investment Company Act, the Investment Advisers Act, the Employee Retirement Income Security Act (ERISA) and any other regulatory exemptions on which they rely.
To avoid having a fund classified as a publicly traded partnership (and thus being subject to taxation as a corporation), interests in the fund cannot be considered to be "readily tradable on a secondary market". Ordinarily, purchases of partnership interests by secondary funds will qualify for safe harbours under the tax regulations and thus will not cause the interest to be readily tradable on a secondary market.
The sale of a partnership interest is a sale of a security that must qualify for an exemption from registration under the Securities Act. The fund and the transferors must ensure that secondary investors are 'accredited investors', as defined in Regulation D promulgated thereunder, and no public advertising can be used in soliciting potential purchasers.
Moreover, depending on whether the fund relies on exemption from registration under Section 3(c)(7) or 3(c)(1) of the Investment Company Act,(1) either the transferee must be a 'qualified purchaser' as defined in that act, or the transfer cannot result in the fund having more than 100 partners. Funds that rely on the '100 or fewer' owner exception under Section 3(c)(1) must be particularly aware of the 'look-though' rules. The act limits the use of multi-tiered pooled investment vehicles to avoid the 100-partner limit by looking though an entity that invests in a 3(c)(1) fund to count the beneficial owners of the investing entity's securities as if they were direct owners of the securities of the 3(c)(1) fund.
One such circumstance is where an investing entity that itself relies on Section 3(c)(1) or 3(c)(7) of the act or is a registered investment company owns 10% or more of the 3(c)(1) fund.(2) Thus, in a 3(c)(1) fund, a buyer and seller may be required to reduce the amount of interests transferred to ensure that the seller entity will not be looked through and the fund will not lose its exemption under Section 3(c)(1).
Furthermore, depending on the regulatory status of the transferee, the fund may be required to comply with other regulations. For example, if the transferee is an ERISA-regulated entity or a subsidiary of a bank holding company, the fund must comply with the applicable provisions of ERISA or the Bank Holding Company Act of 1956, as if the transferee were an original investor in the fund.
As the marketplace for these transactions becomes more sophisticated and competitive, it is important for buyers, sellers and fund managers to understand the dynamics of a secondary transaction and to be prepared for the issues that will arise.
For further information on this topic please contact Emanuel Cherney, Timothy Spangler or Svetlana Milina at Kaye Scholer LLP on by telephone (+1 212 836 8000) or by fax (+1 212 836 8689) or by email ([email protected] or [email protected] or [email protected]).
(2) See Section 3(c)(1)(A) of the Investment Company Act. Furthermore, the staff of the Securities and Exchange Commission has indicated that a 3(c)(1) fund must include towards the 100-owner limit all investors in any investing entity that was "formed for the purpose of investing" in such 3(c)(1) fund. An investing entity generally will be deemed to have been formed for the purpose of investing in a 3(c)(1) fund if, among other factors, 40% or more of its committed capital is invested in such fund.
This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription