Click Here for PDF
This is Part II of Locke Lord’s two-part series on Secondary Transactions. Part I discussed traditional Investor-led Secondary Transactions. This Part II discusses the increasingly dynamic area of Manager-led Secondary Transactions.
1. Manager-led Secondary Transactions, the Investment Proposition.
Just as in the broader Secondaries market as a whole, the Coller Capital and Goldman Sachs Asset Management joint restructuring of a Nordic Capital fund that we discussed in Part I shows the new ascendance of Manager-led Secondary Transactions. The Nordic Capital deal was itself a Manager-led Secondary Transaction, and the deal really shows how Private Equity Fund Managers can utilize the Secondary Market to take a proactive role in offering liquidity options to fund investors.
A Secondary Transaction is no longer a sign of weakness in a fund, rather, a Fund Manager who knows the Secondaries market is now seen as a more capable Manager.
Beyond liquidity considerations, the Secondaries Market may in fact offer higher returns than primaries and even fund of funds investments. Secondary investments are not subject to the early effects of the J curve that hits normal private equity investments, which draw in money for years before reaching the value-creation stage. Secondary investors acquire stakes in mature companies closer to exit. This avoids the risky early-stages of investments and delivers higher returns.
The new environment will require a savvy Fund Manager to be familiar and comfortable with structuring Secondary Transactions according to the Fund Manager's 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.
2. Manager-led Secondary Transactions, Deal Structures.
There are three primary deal structures available to a Fund Manager contemplating a Manager-led Secondary Transaction, the “Tender Offer,” the “Fund Restructuring,” and the “Stapled Secondary.” “GP Spin-outs” can also include a Secondary component.
A. Tender Offer Transactions
Tender Offer Transactions are the simplest, and most similar to traditional LP-led transactions, of the Manager-led Secondary Transaction variants. In a Tender Offer Transaction, the Manager solicits offers from buyers (or a large buyer or buyer-group) to tender for all (or a significant portion) of the LP interests in the Manager’s fund.
The key features of the Tender Offer Transaction are:
- The Manager plays a significant role in coordinating the process among the existing LP investors and the new buyer or buyers.
- Existing LP investors who do not wish to exit the fund, can simply remain in place by opting not to participate in the transfer.
- The Tender Offer Transaction is fast and simple to execute, compared to the Fund Restructuring discussed below.
- Tender Offers usually do not involve completely re-setting the economics of the fund, rather, the only change is usually to extend the term of the fund. Once the transaction is complete, the Manager will hold a vote to extend the term of the fund.
- Federal tender offer rules will typically apply and can impose timing and procedural restrictions on the transaction.
It is also possible to structure a transaction as a hybrid between the Tender Offer and the Fund Restructuring Transaction, through the utilization of side letters and/or feeder vehicles.
B. Fund Restructuring Transactions
In a Fund Restructuring Transaction, the Manager will transfer some or all of the assets of an existing fund (the “Existing Fund”) to a new fund (the “Continuing Fund”). The Continuing Fund will be financed with capital from new investors (or new capital from existing investors), but it will continue to be managed by the same Manager.
Some of the key features of the Fund Restructuring Transaction are:
- Re-mix Investors. Existing Investors are given the option to “cash out” of the existing fund structure, or “roll-over” in the Continuing Fund on the basis of either the Existing Fund terms or the Continuing Fund terms. Existing Investors may also be given the option to commit additional capital to the Continuing Fund.
- Re-set Economics. The Fund Manager has the opportunity to reset the economics of the fund, either through extension of the fee stream associated with managing the assets going forward, or through re-setting the performance metrics and/or claw-back escrow reserves to free up money for the Manager’s employees or other personnel.
- Flexibility. Fund Restructurings are extremely flexible and can be limited to one or only a subset of the assets in the Existing Fund.
C. Stapled Secondary Transactions
In conjunction with either a Tender Offer Secondary or a Fund Restructuring Secondary, an existing LP who is electing to stay put (in a Tender Offer) or roll-over to the continuing fund (in a Fund Restructuring) may be requested, or in extreme cases, required to make additional capital commitments.
The additional capital commitments can be utilized by the Fund Manager to either fund new investments in the Continuing Fund, or form the basis of an entirely new successor fund. Stapled Secondaries mean more capital for the Fund Manager to invest, which could be critical to executing on the investment thesis associated with the existing investments, or it could simply mean renewed life for the Fund Manager to launch a new fund.
D. Applications in the Energy Sector
We believe that Manager-Led Secondary Transactions are set to grow in importance in the energy sector. As Energy Fund Manager’s begin to understand the permutations and appreciate the flexibility of these transactions, their benefits will become self-evident.
Physical assets that fluctuate significantly in value are a defining characteristic of the energy sector. Instead of passively allowing these price fluctuations to wreck entire funds, Fund Managers can utilize Secondary Transactions to roll-over investors, re-set economics, and even create a launch pad for their next fund.