General Partners and Private Equity Secondary Transactions – Certain Regulatory Considerations
Monument Group provides periodic industry and regulatory updates to its clients on various topics related to private equity funds and their distribution. Monument Group has recently formed a strategic alliance with Mozaic Capital Advisors, LLC, a full service boutique firm specializing in secondary market transactions for private equity, real estate and other alternative asset interests. Please feel free to reach out to the contacts listed below should you have any inquiries.
Growth of Secondary Market
Secondary sales of private equity fund interests are emerging as a growing force. The secondary markets were previously attractive to a small number of participants, as investors tried to sell assets at discounts to their net asset value, and general partners (GPs) hesitated to allow the transfer of investment interests in their funds. Things have changed.
Facing public market volatility, a stalled IPO market and prevalence of PE capital available from fundraising, private equity managers see opportunity.
First, GPs see that the universe of sellers has become much larger and more diverse, spreading across all types of institutional investors from banks, to family offices, to endowments, pension funds and even sovereign wealth funds. These sellers may be regulated institutions needing to divest private equity interests due to regulatory changes or other institutional investors simply looking to adjust and/or diversify their private equity portfolios.
GPs similarly recognize that the universe of interested buyers has grown exponentially. Shorter investment terms, J‐Curves and attractive pricing appeal to many new buyers. In addition, buyers like the ability to evaluate the holdings before deciding to purchase a secondary interest in a fund.
With these expansions in the seller and buyer universe, GPs no longer avoid secondary transactions; rather they often court the secondary market directly to increase their own portfolio flexibility. Although the “investor as seller” remains the most common secondary transaction model, two GP‐led models have gained traction among fund sponsors, bringing new opportunities, but each facing their own challenges.
1. Fund as Seller
In the “fund as seller” model, GPs use secondary sales as a strategic tool involving the sale of interests in illiquid portfolio investments. The most popular approach involves secondary directs (also called synthetic secondaries) as a way to unload long‐held underperforming portfolio companies and/or avoid a “zombie” fund containing only hard‐to‐value illiquid investments that have lingered beyond the fund’s targeted lifespan.
A secondary direct involves the sale of portfolios of direct investments in operating companies, rather than limited partner (LP) interests in investment funds. These transactions usually involve the sale of all or substantially all of such portfolio companies simultaneously, rather than the more gradual sale of individual portfolio companies.1
2. Stapled Transactions
Another common GP‐led secondary sale model involves “stapled transactions.” In the earliest versions of stapled transactions, deals were initiated by an LP seeking to sell its share to another LP. As a condition of the GP’s approval, which is often required, the GP requires the new LP to commit to another of the GP’s funds, or to a future fund.
More recently, GPs have used a staple transaction in the form of a fund restructuring tool. In this transaction, the portfolio companies in the GP’s old fund are transferred to a new fund, which can be formed under different terms, including a new return. LPs are offered the option to either cash out or invest in the new fund.
Increased Regulatory Scrutiny
Some in the industry have raised concerns that secondary transactions – particularly stapled transactions – can create conflicts of interests on the part of a GP, particularly with respect to the pricing of the assets to be sold. In particular, a stapled transaction may be used as a tool by a GP in the launch of a new fundraising. By combining a sale of remaining assets in a current fund with a requirement of the buyer to commit to a staple, the GP can simultaneously provide liquidity for investors, as well as secure an anchor investor for its next fund – regardless of how the prior fund performed before the sale. Where a staple commitment is a requirement of a secondary sale, value of the assets available to the seller may be compromised by the staple requirement.
SEC officials are taking notice. Igor Rozenblit, co‐chairman of the private fund unit within the SEC’s office of compliance inspections and examinations said in a speech last Spring that his unit is focusing on the amount of information being provided to LPs involved in stapled secondary transactions, “particularly if there is a decline in the economy,” he said.2 Similarly, Marc Wyatt, then acting director of the SEC’s office of compliance inspections and examinations gave the following caveat at a May 2015 speech: “The private equity industry has experienced strong growth in the past few years, but we all know that private equity markets are cyclical . . . Issues such as zombie advisers and fund restructurings may again come to the fore as we move through the business cycle.”3
The good news is that GPs are taking the initiative to make the secondary process transparent and fair. Industry norms now minimize, if not eliminate, conflicts of interest between LPs, GPs and buyers. GPs also strive to give LPs reasonable choices and to give buyers fair values. GPs are also careful to ensure that neither secondary buyers nor current LPs are disadvantaged by uneven information disclosures.
Likewise, both sellers and buyers are much more savvy. Sellers are careful to ensure that their preparation and proposals incorporate reporting that meets the same demand of due diligence as in the primary PE market. Potential buyers recognize that they can only benefit from the track record of the investment if they can anticipate disclosure of performance and management details, as well as fees and expenses that will affect the future performance of underlying assets.
In summary, the expanding secondary market has brought both challenges – including some regulatory scrutiny – and solutions. Fairness and transparency play an increasingly important part in private equity secondaries, and all parties reap the benefits.
In this context, Monument Group, through Mozaic, focuses on ensuring that secondary deals are selected and brought to market fully prepared for sophisticated buyers, allowing our GPs and investors to garner confidence in the process, transparency and opportunity presented by each transaction.
1 These sales can take the form of (i) sales of groups of portfolio company interests; (ii) distributions of interests in entities that hold illiquid assets; or (iii) distributions in kind to investors of interests in vehicles that own (a) retained assets and/or (b) interests in newly formed entities that are entitled to a continuing interest in particular assets that have been sold or recapitalized.
2 Mr. Rozenblit spoke at the International Finance Corporation’s Global Private Equity Conference (in association with the Emerging Markets Private Equity Association) in May, 2015.
3 Mr. Wyatt spoke at the Private Equity International Compliance Forum in May, 2015.
About Monument Group
Monument Group is a leading, independent private fund placement agent managed by a senior team with significant buy‐side investment heritage. Since its inception in 1994, Monument Group has assisted a range of general partners around the world to raise 76 funds, totaling $84 billion of equity. These clients represent a broad variety of investment strategies including buyouts, debt, distressed, energy and natural resources, growth, infrastructure and real estate. Monument Group has offices in Boston, Hong Kong, London and Tokyo. To learn more about Monument Group, please visit www.monumentgroup.com.
Monument Group, Inc., is a member of the Financial Industry Regulatory Authority (FINRA); Monument Group Europe LLP is authorized and regulated by the Financial Conduct Authority; Monument Group, L.P. is licensed as a Type II Financial Instruments Dealer in Japan; Monument Group (HK) Limited is licensed and authorised by the Securities Futures Commission (SFC) to conduct Type 1 regulated activities in Hong Kong and is exempt from registration in Australia by the ASIC.
About Mozaic Capital Advisors
Launched in September 2015, Mozaic Capital Advisors, LLC is an independent, boutique firm offering full service expertise in secondary transactions. Mozaic Capital works with both large and small institutional investors considering the secondary market for private equity and alternative asset dispositions. www.mozaiccapital.com Securities offered through Monument Group, Inc.
