Liquidity concerns created by the recent financial crisis have resulted in fund managers receiving an unprecedented number of requests by investors to transfer interests in private equity funds. In particular, certain investors need to liquidate some of their holdings, even at low valuations, while others are looking for ways to avoid defaulting on their capital commitments. Although fund managers have, in the past, generally dealt with transfer requests as an accommodation to investors, current conditions may motivate fund managers to be more accommodating to these investors.
- Secondary transfers may help avoid investor defaults, which reduce the size of the investment pool and may have an adverse impact under a fund’s contractual arrangements, including credit facilities. In addition, imposing remedies on defaulting investors may lead to complications and uncertainties in the operation of the fund.
- Because fund managers are generally interested in building a foundation of strong investors for future funds, admitting replacements for defaulting or financially weaker investors is an opportunity to build toward this goal.
- Secondary purchasers investing at today’s reduced valuations may be more inclined to work with fund managers who may be looking to modify the terms of an existing fund or form follow-on vehicles.
- Accommodating a transfer by an investor with liquidity concerns may lay the groundwork for a future relationship once the transferring investor again has capital to invest.
While there are many benefits to facilitating secondary transfers, fund managers should take into account various considerations before approving any transfer request.
Ambiguities in Fund Documents
The transfer provisions in many fund documents do not address situations arising in the current environment. For example:
Manager Acquiring Discounted Interests
Because of liquidity needs or fear of default, investors may be willing to transfer fund interests for deeply discounted prices. For various reasons (including trying to efficiently resolve potential default situations), fund managers may want to acquire these interests for their own account. Fund documentation, however, is often not clear on whether the manager can acquire discounted interests without offering the purchase opportunity to other fund investors. This situation is complicated by the fact that if the investor were to default, in many circumstances, the other investors would be credited with a portion of the defaulted interest. Therefore, there is a potential conflict if the manager acquires the interest at a steep discount prior to a likely investor default. Certainly, if the fund documents give current fund investors a right of first refusal or preemptive rights, those provisions would apply. But even in the absence of those provisions, the manager may be in a difficult situation in deciding whether to acquire the interest and at what price.
Waiving Default Interest
In many circumstances, fund interests are sold after the investor has failed to meet a capital call. Almost all fund documents allow (and some require) the manager to impose late-payment interest charges on a delinquent investor. However, many fund documents do not address whether the fund manager has the discretion to waive interest that has accrued after a default in order to facilitate the sale of the interest. Although the fund manager in such a situation could reasonably take the position that it is in the best interests of all investors to facilitate a sale in lieu of a default, it is more difficult to take this position when the fund documents require that interest be charged.
Heightened Risks for Fund or Manager
Fund managers may face additional credit and other risks from transfers of interests.
Liability for Clawback Obligations
In general, fund-transfer agreements require the transferee to step into the shoes of the transferor with regard to all liabilities associated with the acquired interest. Accordingly, the transferee is typically responsible for meeting all capital call obligations, including those associated with an investor clawback (i.e., a recoupment of prior distributions to cover fund liabilities). In some cases, however, the transferor and the transferee may agree outside of the fund documentation, and without informing the manager, that the transferor will remain liable for these obligations. For example, the purchase and sale agreement between the transferor and transferee, to which the fund and the manager are not parties, may require the transferor to satisfy any investor clawback obligations relating to fund realizations prior to the transfer. In the event that an investor clawback arises in the future, the transferee may take steps to avoid the obligation, attempting to pass responsibility to the potentially financially constrained transferor. While the fund manager would ultimately have the legal right to recover from the transferee, there may be delays, enforcement costs, and potentially, damage to the manager’s relationship with the investor.
Limited Liability Blocker Entities
A transferee may attempt to acquire a secondary interest through an entity that insulates the ultimate purchaser from liabilities associated with clawbacks or other unanticipated capital calls. In prior economic times, many fund managers paid little attention to investors who structured their investments through limited liability, judgment proof entities, especially when these entities were put in place for tax planning purposes. In the current economic environment, however, fund managers must pay attention to the entity that is admitted to the fund as part of a transfer, and should consider requiring parent guarantees for the financial obligations associated with becoming an investor.
Additional Manager Representations
Secondary investors generally conduct due diligence on funds and fund managers as part of their acquisition of a fund interest. Fund managers must balance their desire to facilitate a transfer with the need to protect themselves from potential liability. For example, if a potential transferee is reviewing the fund’s financial statements, the fund manager should make clear in any transfer documents that the financial statements were not intended to be used for (and should not be relied upon for) determining the purchase price of an interest. Managers should be particularly careful not to make representations regarding potential investor clawbacks or recycling provisions. In addition, sharing detailed information with a potential secondary investor that is not shared with all fund investors can create an information asymmetry between the selling investor and the secondary investor, as well as between the secondary investor and the other investors.
Equivalent Treatment of Investors
Fund managers may be faced with the need to deal with defaulting investors several times over the life of a fund. When considering what action to take in a particular situation, a manager should take care to treat all defaulting investors fairly, to take actions that best fit the particular circumstances, to consider the precedent created by its actions, and to consider the best interests of the fund and investors in evaluating default remedies. While different default situations may warrant different responses, investors may question why the manager handled one situation differently from another, and a manager will want to avoid the appearance of arbitrarily imposing a harsher penalty on one defaulting investor than another. Some default remedies, such as the manager itself acquiring the fund interest from the defaulting investor, may benefit the manager or the principals, and give rise to the appearance of impropriety. The manager must take care to minimize, and appropriately address, any actual or perceived conflicts of interest.
Lessons Learned for Future Funds
While the current pressures on fund managers will soon pass, a similar economic cycle is likely to arise at some point in the future, and managers can take steps now to ensure that the transfer provisions in new fund documents reflect the lessons learned from the current economic situation. Some items to consider for future funds include:
- Allowing the manager greater flexibility to facilitate transfers, including by providing the manager (or an affiliate) with the explicit ability to acquire interests from investors, or to force a sale to a third party, without regard to minimum price or offering the interest to other investors. These provisions should provide the manager with significant discretion in determining a fair price, and explicitly state that an auction or third party valuation is not required.
- Allowing the manager the explicit right to waive or reduce interest charges for delinquent investors. While fund documents entered into in connection with future fundraising may become more onerous on defaulting investors, fund managers will need as much flexibility as possible to avoid an actual default and to help attract potential transferees. In particular, the transfer provisions should be coordinated with any forced sale provisions in the case of a default.
- Including extensive disclosures in the offering memorandum about the potential detriments to non-transferring investors from the sale of distressed interests, such as having to bear interest expenses at the fund level to cover delinquent payments, or having to make additional contributions to cover the defaulted amount.
- Considering transfer logistics when establishing a fund structure. For example, a structure that restricts all tax-exempt investors to selling only to other tax-exempt investors may make it more difficult to market fund interests. If possible, build in the flexibility to transfer commitments between fund vehicles in connection with a transfer.