As the GP-led secondary market continues to evolve and reacts to new SEC rules and growing regulatory focus, deal teams are required to navigate an increasingly complex range of issues. Successful dealmaking in this environment requires cross-border and cross-practice legal expertise to find creative solutions to current liquidity challenges and address sponsor conflicts.
Capital constrained markets are shaping structures and terms. While continuation vehicle (CV) fundraising efforts might have featured a single closing point in the past, the market has moved to accommodate multiple closings as GPs seek to accommodate additional buyers and syndications. Strip sales have also become more common. Historically, GPs have transferred entire portfolios from an old fund to a CV, with the deal completely underwritten by the CV. However, as some sponsors struggle to raise capital, we have seen GPs sell a proportion of their portfolio instead, with the selling fund retaining a stake.
With a number of hung CV deals in the market in recent years, partial sales have enabled GPs to execute transactions where CVs have fallen short of capital-raising targets. In these scenarios, the flexibility to cut back investors that do not have tag rights is fairly common.
While this level of flexibility is positive for GPs seeking liquidity, splitting a portfolio between an existing fund and a CV can create conflict issues, including with respect to exit timelines. Deal teams should be mindful of the potential conflict risks at the outset and consider how they will respond if the exit is delayed, including through potential later-stage liquidity transactions for existing fund investors if required (e.g., upon a term extension), such as a third-party tender offer.
While fairness opinions already appear on a majority of CV deals to address valuation conflicts (especially in the US), recently-introduced SEC rule changes for private fund advisers are set to enshrine fairness opinions in law in the US, with the US market set to become the global standard approach, even if the new rules may not technically impact certain non-US structures. The new SEC rules will also place restrictions on allocating fees or expenses related to CV transactions on a non-pro rata basis, unless the allocation is fair and equitable and advance disclosure of the non-pro rata allocation is given. Current US practice frequently allocates deal-related expenses (e.g., representations and warranties insurance, transaction legal expenses, etc.) between the selling fund and the CV on a non-pro rata basis.
As a result, GPs are likely to default to allocating more transaction expenses pro rata, which will impact CV pricing and economics. Deal teams should therefore consider when any expenses might not be borne pro-rata early in the process and make clear and substantive expense disclosures to facilitate investor underwriting.
Beyond SEC rule changes, we have seen other regulators (including the UK Financial Conduct Authority) focus on valuation, ILPA guidance focus on transparency and timing, and a growing range of antitrust, foreign subsidies, and national security regimes impact CV deals. As the CV market continues to evolve, deals will require increasingly sophisticated transactional, advisory, and regulatory experience to achieve desired outcomes.
Our global Investment Funds Practice has experience with all these issues and has advised on a number of recent groundbreaking transactions. We stand by ready to assist.