INVESTMENT MANAGEMENT UPDATE

Transcription

1 FEBRUARY 2009 INVESTMENT MANAGEMENT UPDATE The Investment Management Practice of Sidley Austin LLP Sidley Austin LLP advises clients on a broad range of investment management issues. The firm counsels clients with respect to matters involving the Investment Company Act of 1940 and the Investment Advisers Act of 1940, and is counsel to numerous registered investment companies, private investment entities and their advisers. The firm regularly represents clients on domestic and international transactions and regulatory matters involving investment funds, securities, futures, options, currencies, swaps and other financial products. To receive future copies of Investment Management Update via , please send your name, company or firm name and address to Lisa Kong at [email protected] Investment Management Update has been prepared by Sidley Austin LLP for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, and One South Dearborn, Chicago, IL 60603, Prior results do not guarantee a similar outcome. The Rise of the Private Equity Secondary Market In the midst of the global financial downturn, one area of private equity is growing. The private equity secondary market i.e., buying and selling existing private investor commitments in private equity and other alternative funds has been estimated to have grown from about US$4.4 billion in 1997, to about US$63 billion in The secondary market landscape has evolved significantly in the past two decades. Today, the secondary markets are increasingly viewed as a portfolio optimizing/management tool: sellers view it as a source of liquidity and exit (to an otherwise illiquid investment); and buyers see it as an opportunity to access selective funds or diversify portfolios often at discounted prices, with a partially identified portfolio well into the investment process, and thus leading to quicker returns. Who operates in these secondary markets? Buyers typically secondary funds or seasoned institutional investors fall into two broad categories: (i) secondary funds that are funds formed to acquire limited partnership interests in existing primary private equity funds from investors looking to dispose of such interests, or other opportunistic institutional investors; and (ii) secondary directs or buy-out funds which acquire private equity investments in operating companies (often) from financial/corporate investors or institutions looking to dispose of such investments. Of the two, the former is more common and is the subject of this Client Update. In most cases, an acquiring fund would be structured as a secondary fund limited partnership where investors are limited partners in a fund set up to acquire existing limited partner interests in primary private equity funds. This Client Update discusses reasons for the rapid rise of this market, and salient issues to consider when buying/selling interests in the secondary markets. Why Sell in the Secondary Market? Private equity fund investments, by nature, are illiquid. The interests are not publicly traded, and a typical private equity fund life spans an average of about 10 years where once an investor (investing as a limited partner) makes a commitment to the fund, it cannot discontinue or withdraw its participation without incurring severe penalties 2. During the term of the fund, the limited partner is contractually obliged to meet capital calls to fund new investments, follow-on investments 3, management fees and expenses.

2 PAGE 2 In an economic downturn where limited partners experience a slowdown in distributions and diminished return expectations or have conflicting demands on their cash flow, investors in need of liquidity see the secondary markets as a viable (if not only) option in providing liquidity and ending their ongoing funding commitments. But there are other reasons motivating the sale of fund interests apart from simply cash generation. More recently, secondary sales have also been used as a portfolio management or cash management tool for investors to address, among other things: Changes in Strategy Some investors may need to trim non-strategic investments arising from changes in corporate/investment strategy or post merger/acquisition. Others may divest to manage their financial results, reinvest proceeds, and reduce future funding obligations; or simply to free up administrative resources needed to monitor and manage private equity investment portfolios to focus on key relationships. Other investors may need to sell to comply with governmental compliance restrictions. Denominator Effect Mostly encountered by institutional investors this occurs when the value of different asset classes e.g., stocks and bonds fall, thereby causing the value of the investor s total portfolio (the denominator) to shrink. With the contraction in the denominator, the value of the allocation to other asset classes, such as private equity, exceeds the investor s allocation targets, or allocation restrictions, thereby triggering the need to rebalance the investor s private equity portfolio via divestments/sales. Dissatisfaction with General Partner or Fund Performance Investors sometimes become dissatisfied with the fund management team or performance of the fund and wish to exit. General partners benefit from the secondary market, too. A successful secondary sale can be a timely reprieve for limited partners facing difficulty in meeting future capital calls and avoids the need for general partners to administer the severe penalties for such defaults or disrupt the funding needs of the private equity fund. Why Buy in the Secondary Market? Buyers are drawn to these assets for a variety of reasons: Asset Transparency and Diversification Buyers of secondary partnership interests would typically be able to sight all or a portion of the underlying assets.the longer into the investment period of an underlying fund, the more fully identified is its portfolio of investments.this removes a fundamental risk in private equity fund investments where investors typically invest in a blind pool 4 and allows for more accurate cash flow predictions/return expectations and for price negotiation. Diversification Ability to assess existing portfolio investments and the factors that will influence their performance allows secondary buyers to effectively use secondary purchases as a diversification and portfolio rebalancing tool. Another advantage is that secondary market investors can plan/map the vintage year investments across economic environments and a range of maturities or increase exposure to under-represented industries/geographies, thus providing diversification and boosting investment strategies. Quicker Returns and Discounted Prices When priced correctly, secondary sales have the potential for good returns. Essentially, returns comprise (i) returns generated by underlying portfolio investment assets; (ii) the time value of money effect of buying these assets closer to their liquidity period or to the fund s life cycle generating the majority of distributions 5 ; and (iii) an enhanced return potential by pricing these assets at a discount to their current value. Access to Selective Funds Private equity fund managers particularly the high quality ones typically have a close and long-standing relationship with their limited partners and few new investors are admitted at successive fund raisings. By acquiring an interest in such funds, with the cooperation of the general partners of the funds, buyers can gain access to otherwise exclusive (and sometimes excluding) private equity funds, and a possible opportunity to participate in future funds.

3 PAGE 3 Key Points to Consider Buyers and sellers engaging in secondary fund transactions will likely encounter a myriad of issues, some of which are set out below. This is not an exhaustive list and any party engaging in a transaction is well advised to consult external counsel on issues surrounding the transaction at hand: Valuation and Due Diligence The buyer may need to commit substantial resources for valuation and due diligence, not just of general partners and investment managers of the private equity fund, but also of the underlying assets of the fund. This information is not generally publicly available and is typically subject to an obligation of confidentiality by the seller, which will often require cooperation of the general partner. Valuation may prove a challenge unless the buyer is familiar with the industries and market conditions and can access portfolio company information. Asset valuations provided by the fund s general partner are generally not the sole source of information for the buyer, and are often not relied upon as the sole source of evaluation as (i) they may not be updated on a timely basis post-investment; (ii) may be based on the subjective analysis of the general partner; and/or (iii) may not take into account buyer-specific considerations 6. Compliance with Regulations Most private equity funds are structured to avoid the need to register the sale of their interests, or register the fund under U.S. securities laws 7 ; so it comes as no surprise that parties should be cautious that any transfer should not cause the fund to lose these exemptions or violate any applicable laws. For instance, the fund should be careful that any assignments or transfers will not cause it to lose its exemption under Section 3(c)(7) of the U.S. Investment Company Act of 1940, as amended (to comply, either the fund may require that its limited partners only consist of Qualified Purchasers 8 or the fund may limit the number of limited partners to 100 or fewer); or cause any of the fund assets to constitute plan assets under ERISA, the U.S. Internal Revenue Code or other similar laws.the funds will also require comfort that the sale of limited partner interests does not constitute a public offering and will be exempt from registration under the U.S. Securities Act of 1933, as amended. General Partner Consent Limited partnership agreements almost always provide that any assignment or substitution of limited partner interest will, save for perhaps limited instances such as affiliate transfers, be subject to consent of the general partner, which can be given or withheld in its sole and absolute discretion. The general partner needs to ensure the assignment/transfer will comply with applicable law and regulations, and that the in-coming investor will be able to meet any unfunded commitments to the fund, including the ability to satisfy limited partner giveback obligations, if any. Often, general partners handling secondary transfers also consider operational issues associated with the admission of a new investor, including issues relating to competition and to operational and compliance issues related to the underlying portfolio investment, which might require the consent of third parties as well (particularly where the transfer relates to a sizable interest in the fund). In addition, to the extent that the limited partner commitments to a fund have been pledged by a fund in support of a credit facility to the fund, the consent of the credit facility administrator may also be required. It is also not uncommon for general partners to request indemnification for expenses incurred for effecting the transfers. Parties to a secondary sale should therefore be aware of any potential third party approvals and expenses and engage these parties early in the transaction to minimize any unwanted surprises in closing the transaction. Side Letter and Other Obligations Investors in private equity funds are subject to the obligations created by the limited partnership agreement and subscription agreement of the fund to which they are party, including transferability and confidentiality restrictions, and often negotiate side letter benefits which can provide different economics or rights and/or obligations to the investor. Secondary investors and general partners alike will need to consider whether the buyer, as transferee of the seller s interest, will be entitled to inherit any side letter benefit 9, or will be subject to any side letter obligations. Of course, much will depend on the side letter in question, but

4 PAGE 4 investors should be careful to factor in as part of the purchase terms any such arrangements. Limited Partner Giveback and Distributions Almost all private equity funds provide a limited partner s clawback or look-back provision that essentially requires the limited partner to return distributions made to the limited partner (including former limited partners) for the purpose of meeting the limited partner s pro-rata share of indemnity obligations, payments made in error, or other fund obligations. General partners should ensure that the transferee assumes responsibility for the seller limited partner give-back obligation (apart from other funding obligations) under the transfer documents prior to any release of the transferor, and transferees should be careful to reach an arrangement with transferors on any recall of distributions not priced into the valuation. The transfer documentation should also establish clear accounting arrangements to track the allocation of gains, losses, expenses, distributions, etc., between the transferee and transferor, to the extent not otherwise provided in the fund s limited partnership agreement. Confidentiality Investors are subject to stringent confidentiality obligations under the limited partnership agreement. This may pose some difficulty for parties engaged in secondary transactions: the general partner is concerned with leakage of fund and portfolio company information to third parties as well as potential damage to the reputation of the fund in relation to the sale of the existing limited partner interest, yet the buyer requires such information to assess and price the interest accurately. This problem is frequently addressed by parties entering into appropriate confidentiality agreements setting out appropriate parameters and restrictions on the release and use of such information. However, unless the general partner has agreed with the seller in advance that it will cooperate in the seller s efforts to dispose of its interest, the seller s confidentiality obligations may hamper its ability to provide any information to the buyer, and hamper the buyer s ability to effectively evaluate the limited partner interest being sold. Deal Sourcing Finding sellers of secondary interests is not often easy. Apart from tax reasons (see below), sellers typically do not advertise because of the private placement restrictions against general solicitations or advertising. Additionally, general partners tend to view the sale of an interest in their funds as a negative event that might give others the impression of investor dissatisfaction or, to the extent the sale occurs at a discount, improperly communicate the true value of the fund. Sellers, likewise, often wish to keep both the fact and terms of a sale confidential. As a result, purchase and sale opportunity sourcing is a problem. Unless one is a well regarded secondary market player or an existing limited partner in a fund, deal sourcing is often based on one s network of relationships with investment advisors, general partners and individual limited partners. Tax One important aspect of any transfer in secondary sales is not to cause the fund to be treated as a publicly traded partnership within the meaning of the U.S. Internal Revenue Code, causing the fund to become taxable as a corporation for U.S. federal income tax purposes and lose its flow-through status to investors. Legal Documentation The documents needed to effect the transfer of the secondary interest typically involve a Confidentiality Agreement, Sale and Purchase Agreement (between the seller and buyer) and an Assignment and Assumption Agreement (which also involves the general partner) or such similar documents. However, before the legal documentation can be entered into, the issues described above need to be addressed and resolved, so that the documentation, when finalized, will fully address the aspects of the transfer and future obligations, thus avoiding future uncertainties and unnecessary disputes. As the transfer process can take up to six months, it is prudent for parties to any such transaction to have provisions in the transfer documents addressing changes in valuation prior to the date of actual transfer. As private equity funds face liquidity squeezes and banks are undergoing a major business model adjustment, the current economic environment is accelerating the growth in secondary interests market directly and the formation of secondary funds to take advantage of these purchase opportunities. As the market for secondaries grows, complex and innovative structures and transactions are expected to become more

5 PAGE 5 commonplace. In cases of large portfolio dispositions, unique terms and conditions may apply. Whether in single sale transactions, formation of secondary funds, or large portfolio transactions, legal advisors should be consulted early to analyze the documentation and regulatory restrictions and assist in the negotiations. For assistance in the secondary funds market, please do not hesitate to contact Sidley Austin LLP. 1 Source: Secondary private equity markets booming as banks, others sell partnership by Arleen Jacobius, March 3, 2008 in Pensions & Investments. 2 Typical penalties for failure to meet a capital drawdown may include the reduction or complete forfeiture of the delinquent limited partner s capital account, while still maintaining the limited partner s obligation for its unpaid commitment, the reduction in the delinquent limited partner s interest in profits going forward, or the forced sale of the delinquent limited partner s entire interest for a nominal sum. General partners may also take legal action against delinquent limited partners, although this has historically been rare. 3 Funding for new investments take place over the investment period, which typically could be a period up to 5 years from the start of the private equity investment fund, and funding for followon investments may continue after the investment period, sometimes throughout the term of the fund. 4 Blind pool refers to a form of limited partnership that does not specify what investment opportunities the general partner plans to pursue. 5 During the early years of a typical private equity fund s life, prior to investment realizations, when funds outflows for management fees, organizational expenses and operating or build-up expenses create negative returns. Following the early period of a fund s life, the value of the underlying assets increases and distributions are made creating positive returns. This early trough and later upward slope is known as the J Curve. 6 Valuation for the secondary market buyer may take into account haircuts and other discounts (e.g. for illiquidity), and other adjustments required by regulatory accounting or by credit agencies that are not necessarily related to a fund s performance. A general partner may be reluctant to lower the value of assets based on concerns of loss of face and/or credibility that a lower valuation would cause to the general partner, as well as to existing limited partners who report periodic valuations of their interest for tax, regulatory or accounting purposes. 7 These include the Securities Act of 1933, as amended, the Investment Company Act of 1940, as amended, and the Employee Retirement Income Security Act of 1974, as amended (ERISA) to name a few. Offshore funds are generally not subject to regulation under the U.S. securities laws if shares are not sold to U.S. citizens or residents; however, where offshore funds have some U.S. investors, it will typically rely on various exclusions and exemptions under the U.S. securities laws. 8 Under Section 2(a)(51) of the Investment Company Act of 1940, a qualified purchaser refers to any natural person or family owned company owning at least US$5 million or more in net investments; trusts managed solely by qualified purchasers ; or persons owning and investing on a discretionary basis for their own accounts, or the accounts of other qualified purchasers, at least US$25 million in investments. 9 Benefits included in side letters that may make the interest more valuable to the seller than to a buyer which does not have access to the side letter provisions, may include a seat on the fund s Advisory Committee, the right to transfer the interest (in certain instances without a right of first offer or right of first refusal), a lower management fee, or more enhanced governance restrictions. For further information, please contact: Scott Peterman Partner/ Gaikokuho Jimu Bengoshi, Tokyo Partner, Hong Kong T: / E: [email protected] Effie Vasilopoulos Partner, Hong Kong T: E: [email protected] Doris Lai Counsel, Singapore T: E: [email protected] William D. Kerr Partner, Chicago T: E: [email protected] Susan D. Lewis Partner, New York T: E: [email protected] Gary J. Cohen Partner, Los Angeles T: E: [email protected] Nigel Dunmore Partner, London T: E: [email protected] Bruce Gardner Partner, London T: E: [email protected] BEIJING BRUSSELS CHICAGO DALLAS FRANKFURT GENEVA HONG KONG LONDON LOS ANGELES NEW YORK SAN FRANCISCO SHANGHAI SINGAPORE SYDNEY TOKYO WASHINGTON, D.C. Sidley Austin LLP, a Delaware limited liability partnership which operates at the firm s offices other than Chicago, London, Hong Kong, and Sydney, is affiliated with other partnerships, including Sidley Austin LLP, an Illinois limited liability partnership (Chicago); Sidley Austin LLP, a separate Delaware limited liability partnership (London); Sidley Austin, a New York general partnership (Hong Kong); Sidley Austin, a Delaware general partnership of registered foreign lawyers restricted to practicing foreign law (Sydney); and Sidley Austin Nishikawa Foreign Law Joint Enterprise (Tokyo). The affiliated partnerships are referred to herein collectively as Sidley Austin, Sidley, or the firm.