Secondary Transactions: Risk, Insurance, and Due Diligence

Dierk Flemming: In the private equity world, particularly in real estate and end credit strategies, managers rely on closed-end structures. And by closed-end, I mean there's no liquidity in the fund. So, when you invest, you sign up for a multi-year investment in the vehicle itself. Closed-end strategies are useful to the manager because you have a long runway to deploy capital and a long runway to harvest.

The challenging part for the limited partners (LPs)—the investors in these structures—is the typical investment period runs four to five years, and the harvest period could be another four to five years or even longer. A lot of change can happen for the limited partners over those years.

For example, during the pandemic, people had cash crunch issues and couldn't be locked up for a 10-year term. That's how the secondary market started.  Some smart people said, "I'm going to create a liquidity option for existing LPs in these funds, and I'm going to buy them out and I will stand in the shoes of that original LP."

Secondaries can mean many things depending on who you ask. Sometimes, it's the general partner (GP) who leads the charge and says, “I've gotten feedback from a critical mass of limited partners or investors, and they want a liquidity option now.” And so it is incumbent upon the GP to go find a third-party buyer who will become that liquidity provider to the existing LPs and buy those positions out from multiple LPs. 

A slightly different flavor is continuation vehicle. Sometimes a GP will repackage well-performing assets that are in the existing portfolio into a new vehicle. That gives the existing LPs liquidity if they want to sell their pro rata portion of that exposure or that asset. It's a way for the GP to return capital, and hopefully profit, to that LP in a shorter time frame. 

Lastly, there is what I'd call the LP-to-LP secondary market. And it's huge. Institutional LPs often use a financial advisor to find other potential secondary buyers out there. That individual investor will transact with a new LP in selling their pro rata exposure to, for example, our funds. That's a big market in those instances, and the manager doesn't get involved for many reasons.

The LPs strike their own price, and they transact on their own terms.  The GPs would want to take a very arms-length approach here because they don’t want the terms of the deal to conflict with their view of the fair market value of their fund and its assets. GPs are careful to allow the LPs to strike their own terms, and when they finally come to an agreement, the GP will then consent to that transfer.

Understanding Risks in Transactions

Yelena Dunaevsky: A lot of art versus science goes into figuring out how to strike the right balance. You are on the legal side of things, which means you are constantly faced with all sorts of questions about risks. I'm curious about the typical concerns you see and what risks you want to flag for others.

Dierk Flemming: Depending on the flavor of the transaction, here is a short list of risks: 

• The manager or the GP has to be mindful of potential conflicts and that you're not treating one individual investor better than any other investor. 

• You have to be mindful of tax issues and securities laws (e.g., tender offer rules). 

• Make sure you have a structure that allows for the transaction. If it's a limited partnership, get a limited partnership agreement. You may have to amend your governing documents to allow for the movement of that asset to a new vehicle.  

• Focus on relations with your existing investor pool to do what you can to accommodate their concerns and make sure the new interest holder is excited to be part of your fund.

Yelena Dunaevsky: We are seeing things progress on the insurance side of the market right now, meaning there are insurance products to make these processes go more smoothly than in the past. And that is, of course, fitting the reps and warranties product onto some of these transactions to take away some of that risk from GPs and LPs and reallocate that risk to the insurance carriers.

Many new carriers are stepping into the market that are willing to underwrite not only excess coverage, but also primary coverage. Because there's now a decent amount of competition, the pricing is also very reasonable and is even lower than the already reduced traditional reps & warranties insurance pricing.

Also, insurance carriers are willing to work with participants in secondaries deals to make that process go smoother and to charge reasonable pricing. I don’t know if this favorable environment is going to continue, but for now, it is a very good time to reach out to your insurance broker if you are curious about whether you can get some of that risk covered.

Timelines for Secondaries

Dierk Flemming: GP-led transactions tend to be complex. I would say the typical timeline for a GP-led transaction is usually a year or the better part of a year.

A continuation vehicle, where you're isolating an asset or bucket of assets and repackaging it into a new structure, also has a year or multiple-quarter timelines. You'll engage with an advisor and work with valuation specialists to ensure you're getting the right valuation on the underlying asset that's moving.

With the LP-to-LP transaction, you're setting up a new structure, and investor communication and outreach have to happen. You want to ensure that the LP will not conflict with your existing structure's legal or regulatory issues. However, assuming there is a short list of LPs that look good, these transactions can be completed over the course of a couple of quarters.

Yelena Dunaevsky: Secondaries do take longer than a traditional rep and warranty deal. The runway time there is great on the insurance side of things for the diligence and the underwriting that needs to be done.

What About Due Diligence?

Dierk Flemming: The diligence that we tend to see comes in the form of questionnaires. The buyers really want to know about valuation because, remember, they're striking a deal with the outgoing company to figure out what the price should be.

It is important to find the right advisors like financial advisors, tax advisors, lawyers, and others to ensure that all the i’s are dotted and the t’s are crossed. It is also, of course, important to find the right group of people who will pay a good price for that interest or asset. 

Yelena Dunaevsky: On the insurance side, the diligence process for secondaries is generally more relaxed than that for a traditional M&A deal. The reason for that is that typically, the reps are knowledge-qualified. So, the underwriters see less risk.

The primary diligence pieces needed for a transaction that involves a GP include two underwriting calls, one with the GP and one with the lead investor. There are additional diligence elements that are discussed in the video.

To learn more about secondaries, including thoughts around fairness opinions, and some tips on how to avoid a few pitfalls, watch our entire conversation above.