Articles discussing, and in some cases touting, the secondary market for LP interests have appeared in the financial and popular press. However, to speak of a “market” is a misnomer – there is not a market in a conventional sense. No established market rules, forms, procedures or customs exist. But each transaction does present similar issues that affect the transaction and the parties involved. This article addresses issues related to such secondary trading of which buyers, sellers and general partners should be aware.
The reasons why LPs sell interests affect the what, why and how interests get sold, and include: balancing portfolio of interests for risk exposure; fund focus or industry concentration; percentage interest in any one fund; obtaining liquidity; matching timing of capital calls and distributions; divesting to obtain regulatory consent; creating available investment capital to invest in current vintage funds; dissatisfaction with performance of existing managers or the identity of new managers.
Only the last of these reasons relates to the GP or the performance of the fund. The rest relate to the LP’s internal motivations; usually this other agenda drives the sale, not the quality of the LP interest. Often, the LP will not want the transaction to affect its relationship with the fund sponsor. Balancing these motivations is constrained by having to comply with the requirements in each fund’s partnership agreement regarding transfers of interests.
Peter Gotsch, a partner at Code Hennessy & Simmons LLC, said in his firm’s experience, LPs were making a transfer because of either a change in investment policy – they “did not want to be in private equity for whatever reason” – or a change in portfolio focus by large holders of LP interests. On the buy side, he said Code Hennessy has seen existing LPs as buyers who wanted to increase their allocation to the asset class and by buying an additional interest could “expand their committed capital without learning a new fund.” He added that his firm has been able to use such sales “as a tail on our fund raising” to bring in investors who were interested in the fund but were not able to invest originally.
Notice, Approval and Refusal Rights
Fund agreements require notice to the GP of a proposed transfer and the GP’s approval. Some agreements may require notice to the other LPs. Some funds provide a right of first refusal or first offer to the existing LPs to buy the interest on the same terms as those offered by the proposed buyer. Agreements that provide offer or refusal rights usually have prescribed time periods for the notice requirements, to cut off the time when such rights can be exercised – most others do not. Due to these requirements, the seller must have agreed to sale terms with a buyer before either knows if the transaction can happen. Where the other LPs have a right of first refusal, the potential buyer runs the risk of being a stalking horse, particularly if it has a good deal.
To avoid such problems, parties will sometimes structure the transaction not as an outright sale of the interest but as an assignment to the putative buyer of the economic benefits and voting rights and an assumption of the obligation to fund any remaining capital commitments. This approach is only workable under certain agreements. Many agreements define such arrangements as transfers that require notice to and approval of the GP.
Standards of GP Discretion
The decision by the GP whether to approve any transfer is often left to the GP’s sole and absolute discretion. Some fund agreements specify standards more favorable to the transferring LP. Some provide the GP shall not unreasonably withhold consent. Other agreements go so far as to provide consent will be granted provided certain conditions are satisfied.
Regardless of whether issues are the basis for obtaining GP consent or are not specifically enumerated, every GP has certain issues he or she must consider in evaluating a proposed transfer. The issues include:
Tax – Will the transfer result in the fund being a publicly traded partnership and treated as a corporation for federal taxation purposes?
Securities laws -Because an LP interest is a security under the securities laws, is the proposed transfer exempt for registration under the Securities Act of 1933? Is it in compliance with the 33 Act and is registration of the fund’s securities under the Securities Exchange Act of 1934 required as a result?
Investment Company Act – As most funds are not required to register as investment companies under the Investment Company Act due to the provisions of 3(c)(1) or 3(c)(7), will the transfer result in the fund having more than 100 beneficial owners under 3(c)(1) or will the transferee be a “Qualified Purchaser” under 3(c)(7)?
Creditworthiness – Will the prospective LP be able to make the remaining capital calls (even though fund documents often provide that the transferor and transferee will be jointly and severally liable for subsequent capital calls)?
ERISA/BHCA – If the transferor or transferee is an ERISA regulated entity or a subsidiary of a bank holding company, will the transfer result in the fund assets being treated as “plan assets” under ERISA or will the prospective LP’s ability to make capital calls be limited by the Bank Holding Company Act?
Many of these issues are usually addressed through legal opinions to the GP. Some of these issues, particularly the tax and security law issues, could become more problematic if true “markets” for secondary interests develop.
Typically only interests in which 50% or more of the capital calls have been made are transferred. A transaction usually requires three months to six months, start to finish. The time varies depending on whether one or a portfolio of interests is being sold, the level of marketing and interest in the offered interests, the availability of information from the fund and the time necessary to provide the requisite notices and secure GP consent.
The major out-of-pocket expense is for the legal opinions. In sales of isolated interests, the GP’s counsel will often issue such opinions with the LP responsible for all the GP’s costs. In sales of a portfolio of interests, the transferring LP can exercise some control on this cost by centralizing these opinions with its counsel rather than having each GP’s counsel issue separate opinions. Increasingly, investment bankers or other brokers will handle the sale of LP interests. While this eases the administrative burden, it has an obvious cost. Similarly, valuation firms can assist in pricing, but they too add expense.
The typical issues include:
Valuation – Valuing an LP interest can be frustratingly difficult. Without a standard method or timing by which GPs value their portfolio investments, it is problematic to price an LP interest. GPs are often reluctant to provide detailed financial information for portfolio investments and rarely provide projections. The lower the age of the fund or percentage of capital called, the greater the subjectivity because a greater percentage of the portfolio has not been formed or is not very mature.
Accounting issues – Between the transferor and the transferee, issues can arise with tracking capital accounts; payments of management fees; allocations of gains, losses and expenses; interim distributions and the like. The net effect of these issues is sometimes, but not always, reflected in the purchase price for the interest. Bob Wingels, a partner in Ernst & Young’s Mergers and Acquisitions Tax Group, notes that “taxpaying buyers of these interests often overlook valuable tax planning opportunities which may be available in the purchase of the LP interest.”
Due diligence and confidentiality – Prospective purchasers will need to perform due diligence on the transferred interest. This means assembling a copy of the fund documents: the partnership or LLC agreement, the subscription agreement, copies of capital calls, records of capital contributions, an accounting of distributions and copies of annual reports. It also means obtaining from the GP as much information as possible regarding the fund’s investments. Very rarely will GPs have the desired information available. GPs often require strong confidentiality agreements from the current LP and all parties to whom the information is shown.
Publicity – GPs tend to be adverse to publicity of a possible transfer of an interest in their fund out of concern of creating an impression that investors are dissatisfied. If the LP wants to maintain a relationship with the GP, deference is given to this concern to the detriment of marketing.
Structure – A straightforward assignment of an LP interest is simple to structure and document. Alternate forms of transactions, which may achieve a specific economic arrangement or avoid disclosure of anything to the GP, can increase cost and time.
GPs and LPs can avoid some potential problems by being mindful of the following issues:
Compliance with fund agreement – Being in compliance with the fund agreement is important for diligence and structuring. A default, particularly in meeting a capital call, can trigger GP rights that may make marketing the interest difficult.
Investment Advice – GPs will sometimes feel compelled by their relationship with an LP, or for their own benefit, to advise whether a trade is advisable. Such advice can bring the GP within the purview of the Investment Advisors Act and create potential liability for the GP.
10b-5 issues – Both GPs and LPs need to keep in mind they are involved in the sale of a security. As a buyer of a security, the purchaser of the LP interest can bring fraud claims under 10(b)5 or various common law rights. GPs and LPs need to be sensitive to information they provide and statements they make in connection with any transaction.
Whether entities like PrivateTrade.com can lead to the development of a market, or parties like Lexington Partners, Paul Capital Partners, Willowridge Inc., or dedicated funds like those raised by Goldman Sachs and CSFB can provide sufficient liquidity to take secondary trading of LP interests to another level, it is likely that such trading is not a passing phenomenon. However, these transactions are done, and GPs and LPs should be prepared to participate in the process.
Andrew McCune is a partner in the private equity practice of the law firm of Winston & Strawn.