Over $200 billion in aggregate value is currently held in portfolios of private equity funds that were raised over 10 years ago. How funds should approach these end-of-fund-term situations has become a hot topic for the industry, with fund restructurings emerging as one potential solution. Based on our experience and discussions with other market participants, we expect a significant increase in the number of these transactions.
Executed properly, a fund restructuring can provide existing investors seeking liquidity with a more attractive valuation than would be available to them on the traditional secondary sale market, while offering interested investors the opportunity to continue to benefit from the potential upside in the portfolio and properly aligning the interests of sponsors and investors. But potential landmines abound. A poorly implemented process can result in a failed transaction, significant expenses, angry investors and regulatory scrutiny. Market practice for fund restructurings is still developing, in part because the nature of a fund restructuring does not lend itself to a one-size-fits-all approach. A great deal of creativity, consideration and careful analysis is essential to achieving optimal results.
What Is a Fund Restructuring?
A fund restructuring is a transaction in which new money investors agree to make a significant cash investment to provide a liquidity opportunity to the existing investors in a fund that is approaching the end of its term. The cash is provided to a new fund vehicle, managed by the existing sponsor, that acquires substantially all of the portfolio from the existing fund. Investors in the existing fund are generally given the option either to cash out or roll their interest into the new fund. The terms of the new fund are designed to provide more time for the sponsor to manage the portfolio and to align the sponsor’s interests more closely with those of the investors going forward.
Why are Fund Restructurings Becoming Increasingly Popular?
When a fund has reached the end of its term and still holds a significant portfolio, the opinions of the existing investors (and the sponsor) may differ as to how the portfolio should be managed. Some investors may prefer a short-term liquidation strategy with the goal of near-term distributions and dissolution of the fund. Other investors may believe a longer-term approach, possibly with additional follow-on investments, is a better course for maximizing value. In addition, the sponsor’s economic incentives—including the calculation of management fees and whether carried interest is achievable—may no longer provide effective alignment of interest between the sponsor and the investors. A fund restructuring provides a solution for each group of investors and can also re-align the economic incentives of the sponsor to promote the maximization of value of the portfolio.
The substantial increase in fund restructurings is being driven by several phenomena, including:
- sophisticated secondary investors with substantial amounts of capital looking for attractive deals;
- funds raised during boom times that are now (or will soon be) over 10 years old with billions of dollars in value remaining in their portfolios; and
- the difficulty faced by some sponsors in raising new funds.
When to Consider a Fund Restructuring
Not all funds at the end of their terms are well-suited to a fund restructuring. If the desire for liquidity by certain investors can be addressed through one-off limited partner transfers and the wind down of the portfolio can be achieved with ordinary course term extensions, a fund restructuring may not be necessary. It is when traditional remedies are not sufficient to address systemic issues relating to the fund that a restructuring may be worth exploring. Even in those cases, sponsors should examine a number of threshold issues prior to embarking on a restructuring transaction.
The Portfolio. The portfolio should be large enough to attract the interest of secondary investors. Secondary investors will actively diligence the portfolio and must believe in the potential for long-term value creation. A portfolio with a clear path to liquidity may not be appropriate for a restructuring transaction, as existing investors may prefer that the sponsor pursue a short-term liquidation rather than seeking to restructure.
The Investors. The existing investors will need to be convinced that a fund restructuring presents an effective solution to their concerns. Because of the potential conflicts of interest present in these transactions, the sponsor must have established a level of trust with its investor base and the investors must believe the sponsor is best positioned to continue to manage the portfolio. After all, at the end of the day investor approval will be necessary to complete the transaction.
The Sponsor. A fund restructuring may provide a means for the sponsor to achieve certain objectives relating to the fund, such as re-aligning the fund economics (carried interest and/or management fee) or accessing additional capital, either for the existing portfolio or for new investments. These sponsor concerns may be particularly acute if the sponsor is unable to raise a successor fund and is worried about its ability to retain its investment professionals to manage the existing fund portfolio. A fund restructuring can provide an opportunity for the sponsor to re-energize the firm and its employees and ensure that appropriate personnel are actively incentivized to focus on the portfolio. However, in pursuing its own objectives, a sponsor must ensure it is transparent with its investors about the potential conflicts of interests they may present.
Pursuing a Fund Restructuring
Taking Stock of the Current Portfolio. Early diligence on the portfolio can save significant time and expense later in the process. Even though a restructuring transaction typically is structured as a transfer to an affiliate, regulatory or contractual consents may be required. In addition, sponsors should consider whether certain investments should be carved out from the overall transaction, for example because those investments are close to liquidity or are difficult to value. Finally, if the sponsor has received carried interest, or will receive carried interest as a result of the transaction, the potential of a clawback must be taken into account.
Communication with the Investor Base. Transparency and open communication between the sponsor and the investors throughout the process is essential. The fund’s advisory committee often (though not always) is an effective forum for such communication. Investors may be skeptical, at least initially, of the sponsor’s objectives. The sponsor will need to maintain the investors’ trust, including by being open about the potential benefits the sponsor will receive from the transaction. Investors seeking liquidity will be focused on price maximization and the auction process. Investors planning to roll over will be focused on long-term value maximization and the new fund’s terms. A sponsor will need to be responsive to both groups of investors to achieve a successful transaction.
Fiduciary Duties. As the general partner of the fund, the sponsor generally has a duty to act in the best interests of the fund. The scope of this duty depends upon the jurisdiction of the fund and can typically be modified by contract. However, it can be difficult to translate the sponsor’s duty into practice in circumstances where there are diverging views in the investor base as to how best to manage the portfolio. As such, full disclosure regarding the transaction, including the conflicts and potential benefits to the sponsor (such as stapled subscriptions to successor funds or a carry reset), is important. With full and fair disclosure, the approval of the transaction by a majority (or super majority) of disinterested investors can provide important protection to the sponsor. Careful consultation with experienced counsel in the initial planning stages is critical to ensure the process is designed to minimize the risk of disputes and regulatory scrutiny.
Regulatory Scrutiny. The SEC has made clear that it is closely monitoring the fund restructuring space “to make sure that those creative approaches don’t cross the line and violate federal securities laws.” Potential conflicts of interest the SEC is concerned about include stapled commitments to successor vehicles and other potential sponsor benefits. The presence of potential regulatory scrutiny further reinforces the importance of active dialogue with investors, full transparency regarding conflicts of interest and the creation of a transaction framework that addresses the concerns of each of the various stakeholders.
Auction Process. An agent generally should conduct an auction process to find potential buyers for the portfolio. Investors seeking liquidity will be focused on the auction process and may be concerned about any aspect of the overall transaction that could hinder price maximization. A sponsor may also consider obtaining a fairness opinion from a third-party firm once the price has been negotiated.
Negotiation with the New Investors. Once one or more new investors have been identified in the auction process, other terms of the transaction will be negotiated. These terms include the scope of representations and warranties to be provided, the survival period for claims, the existence of holdbacks or escrows (if any), the conditions to closing and other transactional terms. Typically the terms of the new fund will also be negotiated at this time (more on this below).
Options for Existing Investors. The sponsor should seek to provide fair options that address the concerns of the existing investors—both those desiring liquidity and those desiring to roll over. An SEC official has stated a concern regarding transactions that provide investors with a choice between two bad options. The sponsor should carefully consider the options and seek to avoid any coercive element to the process.
One common request from rollover investors is that they be provided with a “status quo” option. By status quo, rollover investors generally mean no change to their fund economics (management fees and carried interest) and no change to their funding obligations. Whether a sponsor can accommodate this request largely depends on the facts and circumstances of the particular fund, although most recent fund restructurings offer some form of status quo approach. If as part of a status quo approach the rollover investors are not obligated to fund follow-on investments (and such investments are made solely by the new investors), then appropriate valuation and dilution mechanisms will need to be built into the fund agreement.
New Fund Terms
While the starting point for the new fund’s partnership agreement is generally the existing fund agreement, the new fund agreement may differ from a traditional private equity fund in a number of respects. These include:
Distribution Waterfall. The distribution waterfall for the new investors is often one of the more heavily negotiated terms. The new fund’s waterfall may be more complex than a traditional private equity waterfall, including multiple tiers of carried interest based upon achievement of specified multiples or IRR thresholds. As mentioned above, rollover investors may push for a “status quo” waterfall option, and in some cases sponsors may offer the rollover investors a menu of various waterfall options to select from.
Additional Capital. The amount of uncalled capital available from new investors and rollover investors, and limits on the new fund’s ability to make follow-on investments, are frequently negotiated points that are generally dependent on the facts and circumstances of the particular fund. Provisions permitting the recycling of distributions are one tool that can be used to address the potential need for capital while also limiting the obligation of investors to contribute additional capital to the new fund.
New Investments. Fund restructuring transactions may also include an obligation for new investors to commit capital for new investments, either through the new vehicle or as a stapled commitment to a successor fund. An SEC official has expressed concern about transactions that involve stapled commitments to new funds. While these features have been included in some recent transactions, we recommend proceeding with caution and consulting with counsel during the planning stages when a staple may be a component of a restructuring.
Governance, Reporting, Voting. The governance, reporting and voting provisions of the new fund agreement may also be a point of negotiation with the new investors as well as the rollover investors. A significant new investor may seek additional reporting or other rights as a result of its large commitment. On the other hand, depending upon the makeup of the new fund’s investors, a sponsor may wish to revisit the standard voting thresholds for amendments, GP removal, and other matters to avoid a single investor having too much control over such determinations.
We expect the private equity fund restructuring trend to accelerate in the coming years. End-of-term need not always mean the end of a fund’s life. When properly conceived and implemented, and in the right situation, a restructuring can provide a better solution to end of term concerns than the traditional remedies.