Once associated with zombie or “end-of-life” funds holding underperforming assets, GP-led restructurings and other liquidity solutions are increasingly used by healthy GPs to actively manage their fund’s portfolio and boost the fund-raising of their next fund while meeting the varying needs of different investors, some of whom may want liquidity while others may prefer to retain exposure to a fund’s assets. As we predicted in our winter 2016 article, there has been a significant increase in the number of these transactions in both the US and Europe1. This article highlights techniques for achieving a successful fund restructuring with satisfactory outcomes for all stakeholders, in particular safely navigating through potential conflicts of interest.
From Zombie Funds to Active Portfolio Management
A few years ago, GP-led fund restructurings were primarily associated with zombie or “end-of-life” funds with underperforming portfolios. In recent years, we have increasingly seen healthy GPs use restructurings to actively manage their fund’s portfolio while providing a liquidity option to their investors. For example, Warburg Pincus sold last year a $1.2 billion portfolio of Asian investments from its 2012-vintage fund reportedly to reduce its exposure to the region. Some GPs have also used restructurings to boost the fundraising of their other funds. Both EQT’s and BC Partners’ fund restructurings last year are widely reported to have included a stapled commitment to their new funds.
Most GP-led restructurings fall into one of three main categories:
- Secondaries directs: The GP sells the fund’s remaining assets to a secondary investor.
- GP-led LP tender offers: The GP presents an offer from a secondary investor to its existing LPs, who have the option to sell or stay in the fund. LP tender offers can take the form of a liquidity offering with no amendments to the fund terms (other than an extension of the fund’s life) or entail a large or small renegotiation of the fund’s terms.
- “Asset deals” or fund recapitalisations: The assets of the fund are transferred to a new vehicle managed by the same GP and backed by a secondary investor, with existing LPs having the option to “cash out” or “roll over” their interests into the new vehicle.
Asset deals and LP tender offers may also involve a stapled commitment by the secondary buyer to the GP’s next fund. Which of these techniques is most appropriate for a potential restructuring will depend on, among other factors, the LP constituency and the remaining assets in the portfolio.
In general, the techniques of GP-led restructurings are shared across the US and Europe, and both sides of the Atlantic have seen vigorous activity in recent years, although there are technical differences in structuring between the regions (such as the use of statutory mergers in the US).
Last year, GP-led restructurings accounted for 24% of secondaries by deal volume (slightly up from 2016). 2018 is expected to be a strong year too, with Nordic Capital’s restructuring of its 2008-vintage fund being one of the largest GP-led restructurings ever completed.
Not all GP-led restructurings are successful. Last year, Apax abandoned an announced restructuring of its 2007-vintage fund, stating that it was unable to garner sufficient investor support. A successful GP-led restructuring needs cooperation from various parties, and it is important to understand and balance the various conflicting interests in order to achieve a successful outcome.
Navigating Conflicting Interests
A GP launching a fund restructuring should think carefully about the differing interests of all parties involved and manage these appropriately.
The GP is frequently on both sides of the transaction in asset deals (also called fund recapitalisations). The GP owes fiduciary duties to the investors in its existing fund which entails maximising the value of the remaining assets; however, when selling those assets to a new vehicle it will manage, the GP will usually seek to reset the economics in the new vehicle which effectively means that its carried interest in the new vehicle will be tied to the pricing of the assets, potentially creating an incentive for the GP to agree to a lower price. The GP (or an affiliate) may also participate as a buyer, which would again incentivise it to lower the price.
A secondary buyer may support a reset of the economics in order to re-incentivise the team, although in some cases this may not be necessary. In addition, the buyer will typically ask the GP to roll over its interest and make an additional commitment in the new vehicle in order to align its interests with those of the investors in the new vehicle. Depending on the circumstances, the buyer may also seek to limit the number or aggregate size of roll-over investors.
Certain investors will be motivated to sell, whether for liquidity reasons, portfolio management, to lock in gains (and/or limit further potential losses) or otherwise, and will therefore want to sell at an attractive price and limit their liability exposure. There is often sensitivity around the transaction costs and any financial advisor’s fee, and negotiation should be expected as to whether the sellers in LP tender offers and non-rolling investors in asset deals should bear them.
Other investors, who may believe that with time more value may be achieved from the fund’s assets, may seek to maintain the status quo, in other words, to keep the same terms in the new vehicle as in the existing fund, in particular as any accrued preferred return and potential GP clawback may be lost as a result of the restructuring.
Investors who want to stay in the existing fund may feel that a restructuring is premature, especially if the investments are performing well and the existing fund is not at the end of its term. For those who do not want to roll into the new vehicle, there is seldom a “do-nothing” option in asset deals allowing investors to retain their interests in the existing fund, and, whilst fund restructurings can be a great opportunity to build a relationship with new investors and provide a liquidity option to the existing ones, the GP may run the risk of disgruntling some of its existing LPs if it does not manage the process appropriately.
If managed properly, GP-led restructurings can provide a win-win solution both for the GP and the different groups of investors with varying needs.
How to navigate conflicting interests
Transparency is key to navigating these conflicting interests. The GP should strive to communicate with its existing investors as early as possible and fully disclose the terms of the transaction. As to pricing, a third-party valuation and/or a fairness opinion may be obtained to give comfort to the existing investors but may not be sufficient to get their support. As investors gain experience in these transactions, they are increasingly likely to look at the terms of, and question the rationale behind, any proposed restructuring. In Europe, it is increasingly common for fairness opinions to be delivered by third-party advisors, which was previously seen primarily in the US. Depending on the scenario, careful thought should be given as to whether the economics should reset. GPs may be more likely to obtain investor support if the existing investors can maintain their status quo (the same terms in the new vehicle as in the existing fund). This can also be achieved by offering to the roll-over investors the option between two waterfalls in the new vehicle (which can be coupled with additional guarantees in relation to any potential GP clawback that may be lost as a result of the restructuring).
In LP tender offers, the buyer often sets a minimum and a cap on the percentage of interests to be acquired (often on a “first-come, first-served” basis to create momentum). Depending on the circumstances, buyers can also set a cap in asset deals if they wish to limit the number of roll-over investors and will typically seek to renegotiate certain existing fund terms in the new vehicle. For example, buyers may wish to insert new key person provisions to ensure continued management of the assets. In addition, if the GP effectively controls both the new vehicle and the selling fund, the buyer will want to review carefully the scope of the seller’s representations and warranties, including with respect to the assets to be transferred to the new vehicle. Post-closing recourse of the buyer to the selling fund is also likely to be a key point in negotiation, given that the GP generally will want to distribute the purchase price to the non-rolling investors and liquidate the selling fund as soon as possible.
In LP tender offers, the purchase documentation is generally relatively balanced to encourage investors to sell and minimize negotiations, which can be challenging with multiple investors being direct parties to the purchase documentation. US tender offer rules may also impose timing constraints. Sellers in LP tender offers will be concerned with the scope of the excluded obligations (in other words, the obligations that are not assumed by the buyer) and the limitations on liability provisions to ensure that their exposure is limited (as in traditional secondaries), as well as their responsibility for any transaction costs and financial adviser’s fees.
LP tender offers, which do not entail a renegotiation of the fund’s terms, typically provide investors with an option to stay in the existing fund and maintain their status quo (although they may involve an extension of the fund’s term with the buyer heavily influencing investors’ decisions) and therefore can be an attractive alternative if there is a risk of insufficient investor support for an asset deal.
GP-Led Restructurings and Fund Documentation
In the US, the GP’s role in secondaries and their potential conflicts of interest have been under scrutiny by the SEC, which has made several well-publicized comments to this effect. In Europe, these transactions do not seem yet to have caught the attention of the regulators. However, it is worth noting that under the AIFMD, fund managers must have a mechanism in place to avoid conflicts of interest and address them properly where they cannot be avoided.
Fund documents rarely contain any procedure explicitly allowing the GP to carry out a restructuring of the fund. In addition, depending on the structure of the transaction, the existing fund agreement sometimes needs to be amended, requiring the consent of the investors. Asset deals, in particular, can create conflicts of interest (as the GP is frequently on both sides of the transaction), and the advisory committee should therefore be consulted as early as possible in the process. As fund restructurings become more common, advisory committee members are likely to have more experience on these transactions than the GP and may be increasingly likely to focus on the terms of, and rationale behind, the restructuring and not only on pricing. In some cases, a separate legal counsel may be engaged to represent the advisory committee. Advisory committee members may be reluctant to approve a fund restructuring, as it is not a typical role of the advisory committee, or may be conflicted and abstain from voting (and certain partnership agreements are unclear as to whether abstention counts as approval). To avoid these issues, in some cases the GP, following discussion with the advisory committee, has voluntarily chosen to seek a vote of all investors.
As these transactions become more common, should new funds coming to market include specific provisions in contemplation of future restructurings? In theory, a GP could in the fund agreement, seek to give itself enhanced rights to implement liquidity solutions in the future. In practice, however, this has not yet been commonly seen in relation to fund restructurings. It may prove challenging for a GP to find the right balance between spelling out what it might do and retaining enough flexibility (in particular since when a new fund is being raised, it is difficult to anticipate the timing or potential form of a restructuring that may become desirable down the road), and investors will be concerned about giving the GP too free a hand in the future. The standard provisions in current funds have not impeded the trend toward creative solutions, so there is perhaps little need for documentation changes. In any case, most players in the private fund market are now aware of the advantages a well-structured and balanced liquidity solution can afford all stakeholders, and thus the trend is likely to continue.
1Private Equity Fund Restructurings: When End-of-Term Isn’t the End, The Private Equity Report, Winter 2016, Vol.16, No.1.