Much of the private equity activity in 2008 and the first half of 2009 has consisted of secondary purchases and sales of limited partnership interests in private equity funds. In the current economic climate, many existing investors in private equity funds are looking to sell their limited partnership interests for a variety of reasons, including elimination of balance sheet liabilities associated with the obligation to meet future capital calls and raising cash for other purposes such as funding of capital calls in other funds. This week, Anne E. Ross, Paul D. Broude, Paul T. Wrycha and Joseph D. Shumow of Foley & Lardner LLP tell us which Second Market terms are important and what to look for.
This has created a "buyers' market" in which institutional investors and new funds of funds with access to capital have the opportunity to buy private equity fund limited partnership interests in the secondary market at discounts from face value. These discounts have been reported to be as high as 50 to 70 percent. In mid-April 2009, Goldman Sachs Asset Management closed on GS Vintage Fund V, its fifth such fund, with $5.5 billion to invest in private equity investments in the secondary market. Less than two weeks later, HarbourVest Partners, LLC closed on a new $2.9 billion fund for the same purpose. Recently, the Financial Times reported that JPMorgan Chase is raising a fund for the same purpose.
This alert summarizes the driving forces behind the increased activity in the secondary market for limited partnership interests in private equity funds and describes some of the important terms buyers, sellers, and general partners should anticipate.
Why the Secondary Market Is Growing
The growth of the secondary market for limited partnership interests in private equity funds is largely attributed to the economic downturn. Private equity funds are generally organized as partnerships, with the investors as limited partners and the fund manager as the general partner. Private equity fund securities are intended to be held for long-term investment by the original investor; funds typically have terms of 10 years or more and rarely offer redemption rights for their limited partners. Moreover, most funds provide for obligatory capital contributions throughout the fund life in response to capital calls from the general partner. Failure to meet such capital calls can give rise to severe penalties imposed on the defaulting limited partners, including the general partner's ability to: (i) discontinue future distributions to the defaulting limited partner, (ii) restrict the defaulting limited partner's ability to vote on limited partner issues, (iii) cause the defaulting limited partner to forfeit its interest in the fund, and/or (iv) cause the limited partner to sell its interest in the fund to the fund's other limited partners at a discount.
In a growing economy, private equity funds often exit their earliest portfolio investments, via a sale or initial public offering, midway through the life of the fund, providing cash flow with which the limited partners can fund their remaining capital contributions or make new commitments to other funds. As the economy slows down and the credit and IPO markets tighten, it becomes more difficult for private equity funds to exit their investments in portfolio companies. This lack of liquidity is further exacerbated when the stock market experiences a substantial downward correction like the U.S. markets experienced in the first quarter of 2009. Limited partners who normally may be able to access the public markets to liquidate portions of their holdings to finance capital calls may not want to do so when the market is substantially down. As a result, many limited partners find themselves in the middle of the perfect storm with unfunded capital contribution obligations, which are recorded as balance sheet liabilities, and no liquid appreciated investments with which to fund these obligations. Thus, a sale of the limited partnership interests, accompanied by an assignment of the unfunded obligations, is often the best of several bad alternatives for the limited partner.
Even if the economy had not turned in the fourth quarter of 2008, the secondary market would likely have seen an increase in activity. Historically, the secondary market booms in the years following a boom in the primary market. And "boom" is exactly what happened in the primary market in 2006 and 2007. In 2007 alone, private equity funds invested nearly $700 billion globally, double the amount invested in 2005. In the same year, private equity funds raised an additional $500 billion of new capital. History correctly predicted that the secondary market's boom was not far behind.
The combination of the foregoing factors has resulted in the supply of private equity fund securities available for sale exceeding the capacity of those looking to purchase. Regardless of the reason for a seller entering the secondary market, many of the same issues will arise in negotiating the purchase and sale of equity interests on the secondary market.
What Terms to Look for in Secondary Market Transactions
The following deal points remain key provisions for secondary market sales:
Price. To calculate the purchase price, the parties typically fix a "cut-off date" as of a recent net asset value (NAV) determination. The parties then negotiate a premium or discount to NAV as of the cut-off date. In this market, except in very rare circumstances, the purchase price will likely be a discount to NAV.
Post-closing adjustments to price. Because the cut-off date and the closing rarely occur simultaneously, post-closing adjustments to the purchase price may be necessary. Any distributions by the fund to the seller will decrease the purchase price, since these funds would have been distributed to the buyer had the closing taken place on the cut-off date. Likewise, any funding of capital calls between the cutoff date and the closing will result in an increase to the purchase price, since this capital contribution would have been the buyer's responsibility had the closing taken place on the cut-off date.
Indemnification. As in any transfer of assets, indemnification will be an issue. A typical provision for a transaction in the secondary market will cover which party is responsible if a fund requires a return of distributions (sometimes referred to as a "clawback"). The appropriate allocation of responsibility for funding a clawback obligation may turn on whether the distributions being recalled were made prior to or after the cut-off date. Sometimes, however, a clawback will involve more than one distribution that straddled the cut-off date, in which case a pro rata return of distributions may be appropriate. As is common in other indemnification provisions, the parties may set maximum indemnification amounts and decide whether to use a "true basket" or a "tipping basket" provision.
Material adverse change clauses. As buyers have gained greater leverage in negotiations, material adverse change, or MAC, clauses are increasingly used as a condition to the buyer's obligation to close. Pursuant to a MAC clause, a buyer need not close a purchase of private equity interests if there has been a MAC. What constitutes a MAC, however, is a heavily negotiated point.
Side letters for buyers. Like MAC clauses, side letter requests increase when buyers have greater negotiating leverage in the secondary market. A side letter can cover nearly any topic, but the most common purpose for a side letter is to grant the buyer a seat on the fund's advisory committee. This provision, like other provisions discussed in this section, must be approved by the general partner. Unlike other provisions, however, this provision is likely to be a point of discussion between only the general partner and the buyer. A buyer will typically have leverage in these discussions, if the general partner has reason to be concerned that the seller might default on future capital calls, or if the buyer is viewed a likely investor in future funds (see "Staple transactions" below).
Staple transactions. While MAC clauses and side letters may be on the rise, so-called staple transactions are on the decline. Because general partners must consent to a transfer of equity interests from the seller to the buyer, general partners have traditionally had some leverage in negotiations. One way general partners have historically used that leverage is to require the buyer to commit to invest in the general partner's next fund. In this regard, the two transactions (one in the secondary market and one in the primary market) are "stapled" together. With the flood of sellers in the secondary market, however, general partners are in a weakened negotiating position. If a general partner wants a buyer with more cach, not to mention if the general partner wants a limited partner that can make its capital calls, the general partner is less likely to push for a staple transaction. Nevertheless, this is an important deal point that will likely come up in negotiations.
Future participation by sellers. Another deal term that is waning in popularity is the seller's right to continue to participate in distributions of the fund after the closing on the sale of the limited partnership interests. In 2003 and 2004, when the secondary market was more favorable for sellers than it is now, some sellers were able to negotiate the right to participate in the future "upside" of a fund. With the high supply of private equity interests in the secondary market, though, this provision has generally gone the way of the staple transaction.
Other issues will arise, including some that are similar between the primary and secondary markets. For example, each party will typically look for subscription-style representations and warranties from the other parties. The buyer in the secondary market should expect to be asked to represent that it is a sophisticated investor, that it is not subject to ERISA, and that it is an accredited investor for securities law purposes. Similarly, the seller in the secondary market, the fund, and the general partner of the fund should be prepared to represent that they have not run afoul of the securities laws prior to the contemplated transaction.
ConclusionThe increase in activity in the secondary market will continue to lead to new issues, new provisions in transaction documents, and new transaction structures altogether.
Anne E. Ross, Partner, Madison, Wisconsin, firstname.lastname@example.org
Anne E. Ross is the managing partner of the Madison office of Foley & Lardner LLP and is a member of the Private Equity & Venture Capital and Commercial Transactions & Business Counseling Practices, as well as the Life Sciences and Insurance Industry Teams. She serves as counsel to venture funds, institutional and angel investors, and public and private companies in a variety of technology-driven industries.
Paul D. Broude, Partner, Boston, Massachusetts, email@example.com
Paul Broude is a partner in the Transactional & Securities and Private Equity & Venture Capital Practices with Foley & Lardner LLP. Additionally, he is vice chair of the firm's Emerging Technologies Industries Team and a member of the Life Sciences Industry Team. He represents a wide range of publicly and privately held companies, entrepreneurs and private equity funds in technology and other business ventures.
Paul T. Wrycha, Partner, Madison, Wisconsin, firstname.lastname@example.org
Paul T. Wrycha is a partner in the Private Equity & Venture Capital and Transactional & Securities Practices, as well as the Emerging Technologies and Life Sciences Industry Teams with Foley & Lardner LLP. He practices in the areas of mergers, acquisitions and leveraged recapitalizations; public and private offerings of equity securities and federal securities law compliance.
Joseph D. Shumow, Associate, Madison, Wisconsin, email@example.com
Joseph D. Shumow is an associate in the Private Equity & Venture Capital Practice and Energy Industry Team with Foley & Lardner LLP.
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