Conflicts of Interest in Secondaries

In recent years, GP-led secondary transactions have become increasingly popular. They are no longer seen solely as vehicles for disposing of tough-to-sell assets. Instead, they are gaining recognition as an active portfolio management tool, used to liquidate fund assets, often at a better valuation compared to a traditional disposition.

Stapled Deals

One such way that a GP disposes fund assets in the secondary market is by way of a stapled deal. A stapled deal is a transaction in which a GP sells an interest in an existing fund, oftentimes at a discount, to a buyer who then commits to buying a stake in the GP’s new fund. Stapled deals have benefits for both the GP, and the selling LPs. For the GP, it allows it to close older funds; steering the fund away from becoming a zombie, as well as ensuring a commitment to invest money in the GP’s new fund. For the LPs, it offers an opportunity to liquidate for those investors that were seeking an exit.

At the outset, this appears to be a beneficial outcome for all parties involved. However, there is potential for a conflict of interest to arise in stapled deals where the GP sells the assets to the buyer at a discount.

The Conflict

The GP will often be on both sides of the stapled transaction -owing a fiduciary duty to the LPs of the existing fund, as well as prospective LPs in the new fund. The conflict is one of valuation; specifically, price optimization. In essence, the GP owes a duty to existing LPs to obtain the highest possible price for the assets, while simultaneously, owing a duty to prospective LPs of the new fund to acquire the assets for the lowest possible price.

GPs who go the route of a stapled transaction must be aware of the potential conflicts inherent in them, and as such, must manage the process accordingly to avoid them.

How to avoid a conflict?

For stapled deals, a conflict of interest can be avoided through complete transparency. The GP can demonstrate transparency by doing both of the following:

● Full and Timely Disclosure
GPs should disclose to LPs whether discounted pricing or favorable economics for new investor commitments in the continuation fund were linked to buyers that have also committed to providing stapled primary capital in the GP’s new fund. GPs should provide LPs with detailed information on the basis of the assumed price and multiple for the assets, including detail on valuation and modeling assumptions used. Limited Partner Advisory Committee (LPAC) members whose members are also participating in the process as bidders should disclose their involvement and recuse themselves from any formal deliberation or vote on the transaction, and/or any waiver of conflicts of interest related to the process.

● Obtaining a Fairness Opinion
As the Net Asset Value (NAV) is typically determined by the GP, acquiring a fairness opinion from an independent financial advisor will be helpful in informing the selling LPs that a fair price was obtained.

What not to do

GPs should not reduce the NAV in an asset to create the impression that the buyer was buying the asset at par value. Taking advantage of LPs will attract the attention of the Securities and Exchange Commission (SEC) and might warrant the imposition of penalties. Over the past couple of years, the SEC has handed out fines to multiple firms that knowingly undervalued fund assets in order to bring in buyers.

Bottom line

In order to avoid conflicts of interests in stapled deals, GPs must make full and timely disclosure to their LPs, and should consider acquiring a fairness opinion to demonstrate to the LPs that a fair value was obtained for the underlying asset. It is unwise for a GP to reduce the NAV of the asset to attract buyers and secure a commitment for the GP’s new fund. GPs must keep in mind that their LPs are completely reliant on them in stapled transactions, including, setting the NAV of the asset. As such, the ball is in the GP’s court to disclose all of the details of the deal and its alternatives to the LPs, even when disclosing such information is not in the GPs favor.