Checklist for Purchasing Private Equity Fund Interests on Secondary Markets
Institutional investors have increasingly traded in interests in private equity funds over the past few years. The horizon for private equity fund investments is typically long: the invested capital may remain committed to the fund for as long as ten years, and often the investment cannot be redeemed during that period.
As trading in fund interests has become more active, investors have had better opportunities to realise their private equity fund investments prior to the expiry of the fund’s term. This has made private equity fund investments easier and quicker to liquidate. Active secondary markets also offer interesting investment opportunities to buyers such as private equity funds specialising in secondary markets (called secondary funds).
If you are planning on buying or selling an interest in a private equity fund, it is worth preparing the process and agreements with care. This post is a checklist of a few of the most important legal questions to focus on.
1. What Documentation Do You Need?
You should determine what documentation you need for the deal at the very beginning of the process. This will help avoid surprises and delays at the critical closing phase.
At least two agreements are usually needed:
- A sale and purchase agreement between the buyer and the seller that sets out the legal and commercial terms of the deal.
- A transfer agreement between the buyer, seller and the fund that defines the technical implementation of the transfer and tasks and rights of the fund manager or management company.
The sale and purchase agreement deals with the rights and obligations of the parties to the deal that do not relate directly to the target fund. The target fund and its fund manager are rarely parties to the sale and purchase agreement.
2. What Consents or Processes Does the Transfer Require?
The fund agreement and other governing documents of a private equity fund often restrict the transfer of fund interests. It is common for the transfer of a fund interest to require at least the consent of the fund manager or the general partner of the fund. In some cases, the transfer must be notified to the other investors in the fund, and sometimes the general partner or other investor has the right to redeem the interests proposed to be transferred. In addition, the transfer may require the consent of the fund’s lender or could involve requirements relating to the creditworthiness or regulatory status of the transferee.
It is also important to check the legal form of the fund as the legislation applicable to that form will affect what measures are required for the transfer. In addition, the buyer should keep in mind that the seller may have agreed to supplementary terms to the fund agreement in a ‘side letter’, which is not usually transferrable to the buyer unless expressly agreed.
The sale and purchase agreement nearly always sets forth that the closing of the transfer is conditional on the completion of notification and approval procedures and other procedures required by the fund agreement.
All of the terms of the fund agreement that affect the transfer of fund interests and the registrations and other measures required to complete the transfer should be mapped out as early in the process as possible. This is to ensure that any transfer restrictions can be taken into account in the timetable for the process and in the conditions for closing of the sale and purchase agreement.
3. How Is the Purchase Price Determined?
Private equity fund investments are usually made as commitments. This means that the investor does not pay the invested capital to fund all at once when joining the fund, but in instalments over several years as the fund manager issues capital calls.
The fund uses the called capital to finance its investments and other capital needs.
Correspondingly, the fund makes distributions to the investors in instalments as the fund accrues distributable assets. The fund agreement may also include terms according to which some of the assets distributed to investors can be called back into the fund under certain circumstances.
Because of this structure, it is important to understand the financial characteristics of the commitment when buying a fund interest:
- What is the total amount of funds that have been drawn down under the commitment that is subject to the transfer?
- What further amounts can be drawn under the commitment?
- What distributions has the fund made to its investors?
- Can any of the prior distributions made by the fund be called back by the fund?
The financial impact of these items must be taken into account when calculating the purchase price and price adjustment mechanism for the fund interest. The foundation for negotiations concerning the purchase price is typically the latest valuation reported by the fund (typically quarterly), and a certain percentage discount (haircut) or increase (premium) may be agreed to that valuation.
The purchase price of a fund interest and any agreed haircut or premium to the latest valuation reported by the fund are based on commercial negotiations between the parties.
The sale and purchase agreement typically also provides terms for adjusting the purchase price on the closing date if the fund has made distributions or issued capital calls to the investors between the fund’s latest valuation reporting date and the closing date.
4. How Are Obligations Distributed?
The main principle is that the buyer gets the right to distributions by the fund and takes on the payment obligations relating to the fund interest. However, it is worth considering the allocation of certain obligations in more detail.
These include, for example, obligations relating to any clawback clauses in the fund agreement that may require investors to return amounts distributed by the fund.
Clawback clauses are terms of a fund agreement that provide that the general partner of the fund or investors in the fund may be obligated to return amounts distributed by the fund. Investors may be required to return prior distributions to the fund, for example, to cover liabilities realised by the fund.
It is in the buyer’s interest to avoid a situation in which proceeds have been distributed to the seller before the deal, but the clawback obligation relating to those proceeds falls on the buyer after the deal.
It is also in the buyer's interest to agree on how to handle any tax liabilities of the seller and any breaches of the fund agreement or the representations and warranties included in the subscription documentation prior to the completion of the deal.
Limitation of liability is generally one of the key issues when negotiating the sale and purchase agreement. The end result depends on the characteristics of each fund and by the negotiation position of the parties.
5. Is It Possible to Prepare for Changes In Market Conditions In The Closing Terms?
No one can know precisely what effects outside factors, such as the knock-on effects of the COVID-19 pandemic, could have on the prospects and yields of private equity funds operating according to different strategies.
Particularly when there is a long gap between the signing and closing of the sale and purchase agreement, the buyer may want to mitigate risks through closing conditions in the sale and purchase agreements (also called material adverse change or MAC clauses). These kinds of clauses make it possible to withdraw from the deal if one of the material adverse changes defined in the agreement occurs between the signing and closing of the agreement.
Sellers naturally take a dim view of MAC clauses, as they reduce deal certainty. Sellers often argue that changes in market conditions are part of the normal operating environment of private equity funds and that changes balance out over the long terms of funds.
Here too, the allocation of risks ultimately comes down to the characteristics of each deal and the parties to it. To date, the pandemic does not seem to have caused a significant increase in the use of MAC clauses in fund interest sale and purchase agreements.
In addition to the key issues described above, there are a number of other matters that need to be taken into account. The terms of any deal will be affected by the characteristics of the fund in question, such as the fund's structure, the commercial and legal terms of the fund agreements and the tax treatment of the fund investment. The buyer should make sure these are covered in the due diligence review.
Not all of the matters that the buyer is interested in may be found in the fund agreements. If so, additional information can be sought in the fund's financial reports, tax memos or directly from the fund manager.
In order to ensure an efficient purchase process, it is also important for the seller to carefully review the key fund documentation and understand what boundaries it sets for the process and terms of the deal.