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In April 2018, Coller Capital and Goldman Sachs Asset Management paid $2.9 billion to buy out existing limited partners in a fund raised by Nordic Capital in 2008. In the months following the Nordic Capital deal, it has been widely seen in the industry as a turning point for transactions in which new investors buy interests in private equity funds from existing investors (a “Secondary Transaction” or a “Secondary”).
Previously, the Secondary Transaction market was dominated by distressed sellers and there were only a few investors interested in making acquisitions. But 2018 saw the Secondary market go mainstream, and now both fund managers and fund investors are waking up to the huge array of possibilities presented by Secondary Transactions.
We fully expect this trend to carry over into the Energy sector, and for private equity funds in the sector to begin to experience a continuous and vibrant secondary market, which will lead to greater liquidity and better alignment of interests between fund managers and fund investors, going forward.
The new environment will require a savvy fund manager to be familiar and comfortable with structuring Secondary Transactions according to his own goals and the goals of his investors. A manager should also know that secondary interest transfers raise the specter of his fund being classified as a publicly traded partnership (“PTP”), and how to structure and time such transfers to take advantage of the safe harbors available, which allow a fund to avoid PTP classification. In practice, these considerations are extremely important to the success of a Secondary Transaction because a fund that becomes classified as a PTP may be separately taxable as a corporation, not a pass-through partnership.
This Locke Lord QuickStudy on Secondary Transactions is a two-part series, which will introduce our readers to the two main categories of Secondary Transactions:
(1) Investor-led Secondary Transactions
(2) Manager-led Secondary Transactions.
Investor-led Secondary Transactions
1. Seller and Intermediary Initiate. In an Investor-led Secondary Transaction, either the Seller will generally initiate the transaction through approaching an intermediary (such as a strategic advisor or an investment bank, the “Intermediary”).
2. The Seller and Intermediary Find a Buyer. The Seller and Intermediary will identify a portfolio of marketable fund interests held by the Seller that it wishes to sell (the “Portfolio Interests”) and prepare information and due diligence materials to allow potential Buyers to evaluate the Portfolio Interests as a whole and to adequately diligence each individual interest (although it is important to note that the Seller will likely only have the quarterly and annual reports provided to it by the managers of its Portfolio Interests).
3. Engage the Manager. Once the Buyer is identified and the price agreed, the Buyer and Seller will formally notify the fund manager (the “Manager” or the “GP”) of the proposed transactions.
4. Transfer Procedures. Nearly all private equity fund partnership agreements (the “Partnership Agreement”) require the Seller to obtain the prior written consent of the Manager prior to transferring its interest in the fund, and the Manager will have discretion to reject the transfer as well as require the Seller to fulfill conditions precedent to making a transfer (such as causing the Buyer to undergo investment vetting by the Manager). Many Partnership Agreements also specify that interest transfers will only be deemed effective monthly, quarterly, or even annually. There are also many Partnership Agreements which give other investors in the fund a right-of-first refusal over any transfers (the “ROFR”). Therefore, when planning a Secondary Transaction, it is imperative to leave ample time for the procedures of the transfer.
5. Legal Documentation.
A. The Buyer and the Seller will enter into a Purchase and Sale Agreement (“PSA”), which will provide for the commercial terms of the deal, including but not limited to price, Portfolio Interests, excluded obligations, reps and warranties, liability caps, deferred consideration (if any), publicly traded partnership risks and safe harbors, the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”), and other tax issues. The PSA is usually kept confidential from the Manager (Managers frequently do not know the price of a Secondary Transaction involving their own fund).
B. The Buyer, Seller, and the Manager will enter into a document that actually transfers or assigns each Portfolio Interest (the “Transfer Agreement” or “Assignment Agreement”). The Buyer will also complete a subscription booklet (the “Subscription Booklet”) for each Portfolio Interest. And finally, the Manager may require other ancillary documentation, such as a legal opinion in respect of PTP risks and safe harbors.
6. The Energy Sector.
The principal advantage of an Investor-led Secondary Transaction is that it can free up Investor capital for new investments. Energy investors have long been familiar with the concept that returns on an investment can be front-loaded. For instance, many natural gas wells can return up to 80% of lifetime revenues within the first five to seven years of a well’s producing life.
An energy-focused fund can experience hyperbolic, and then exponential, decline in returns after the initial years, with the tail-end of the returns being a radically different investment proposition from the initial maximum production returns, potentially even harming overall returns. However, even with the lower returns, tail-end funds can be attractive to investors who think some of the assets held in the Portfolio Interests could turn a profit. A Secondary Transaction can be used here to transfer the tail-end to a new investor with a tailored investment strategy and allow the original, high-return, investor to free up capital for new investments.
7. Conclusion. This has been Part 1 of a two-part series on Secondary Transactions. Part 2 will discuss Manager-led Secondary Transactions.