Cross fund trades may provide an out for mandatory fairness opinions

Buried on page 192 in footnote number 576 of the US Securities and Exchange Commission’s 660 page private fund proposals, which were voted through last week, is a little caveat that appears to render one of the regulator’s main new rules null and void.

The SEC last week mandated that continuation fund transactions – a market worth around $38 billion last year, according to estimates by Evercore – are required to have a third-party fairness or valuation opinion in the interest of protecting investors in the selling fund. Such third-party opinions would provide an “important check” against a GP’s conflict of interest in such transactions, the regulator said.

The footnote on page 192 states that the SEC would not enforce this rule on cross-fund trades – also known as rollover co-investments – where the GP “does not offer the private fund’s investors the choice to sell, convert or exchange their fund interest”. In other words, a GP selling an asset from a prior vintage fund into one of its more recent vintages where the original fund’s LPs have no ability to “roll over” their fund interest, for example, would be exempt from the mandatory fairness/valuation opinion rule.

Cross-fund trades do not require LPs to elect what to do with their exposure, therefore, structuring a continuation fund as a cross-fund trade – as some secondaries lawyers do on behalf of their clients – would negate the requirement for a third-party opinion and burdens that come with that, such as added time and fees. This, despite the fact that in both cross-trades and continuation funds, the GP is conflicted as it is acting as both a buyer and a seller.

Recent examples of cross fund trades include CVC Capital Partners’ transaction last year with business services company TMF Group in which it sold a 50 percent stake to Abu Dhabi Investment Authority and reinvested via its long-hold fund, and Bain Capital’s sale of its stake in labels and packaging products maker Fedrigoni to BC Partners.

In July, affiliate title PE Hub Europe reported that IK Partners was in talks to sell its stake in IT and cybersecurity services firm Pr0ph3cy Group and would reinvest alongside acquirer Carlyle and the company’s management team.

GPs are even using dedicated so-called “double down” funds to execute cross-fund trades in a systematic way, with TA Associates and Insight Partners having both raised such vehicles.

Given their popularity, could more continuation funds now be structured as cross-fund trades, given the protection this footnote appears to provide?

“I do think structuring secondaries as a cross trade provides another option in the secondaries toolkit where a fairness opinion or valuation opinion may not be cost effective or appropriate,” said Adam Tope, a partner at DLA Piper who works on fund formation and secondaries. Cross-trades are simpler from a regulatory perspective as they are tried and true – plenty of guidance exists on how to complete a cross trade in compliance with the Advisers Act, he noted, adding that funds have been effecting cross trades for a long time and that the SEC has stress-tested such transactions.

“While we often get fairness opinions or other valuation opinions when using cross trade structures, it was comforting to see an explicit acknowledgement of this type of structure.”