Liquidity concerns created by the recent financial crisis have resulted in fund managers receiving an unprecedented number of requests by investors to transfer interests in private equity funds. In particular, certain investors need to liquidate some of their holdings, even at low valuations, while others are looking for ways to avoid defaulting on their capital commitments. Although fund managers have, in the past, generally dealt with transfer requests as an accommodation to investors, current conditions may motivate fund managers to be more accommodating to these investors.
- • Secondary transfers may help avoid investor defaults, which reduce the size of the investment pool and may have an adverse impact under a fund’s contractual arrangements, including credit facilities. In addition, imposing remedies on defaulting investors may lead to complications and uncertainties in the operation of the fund.
- • Because fund managers are generally interested in building a foundation of strong investors for future funds, admitting replacements for defaulting or financially weaker investors is an opportunity to build towards this goal.
- • Secondary purchasers investing at today’s reduced valuations may be more inclined to work with fund managers who may be looking to modify the terms of an existing fund or form follow-on vehicles.
- • Accommodating a transfer by an investor with liquidity concerns may lay the groundwork for a future relationship once the transferring investor again has capital to invest.
While there are many benefits to facilitating secondary transfers, fund managers should take into account various considerations before approving any transfer request or attempting to acquire an interest for their own account. Below are some of the issues a fund manager should consider in connection with any potential default and resulting secondary transfer.
- • Can the manager acquire discounted interests for its own account? Fund documentation is often not clear on whether a manager can acquire discounted interests without offering the purchase opportunity to other fund investors. This situation is complicated by the fact that if the investor were to default, in many circumstances, the other investors would be credited with a portion of the defaulted interest.
- • Can the manager force a transfer? Such a provision would allow the manager greater flexibility to facilitate transfers or to force a sale to a third party, without regard to minimum price or offering the interest to other investors. These provisions should provide the manager with significant discretion in determining a fair price and should explicitly state that an auction or third party valuation is not required.
- • Can the manager waive interest charges on the defaulted contributions? Almost all fund documents allow (and some require) the manager to impose late-payment interest charges on a delinquent investor. However, many fund documents do not address whether the fund manager has the discretion to waive interest that has accrued after a default in order to facilitate the sale of the interest, even when waiving any interest charges may be in the best interests of all investors to facilitate a sale in lieu of a default.
- • Have the non-defaulting investors received appropriate disclosure? There are consequences to non-defaulting investors in connection with the sale of a distressed interest. In addition to the reduced valuation of their investment, the non-defaulting investors may have to bear interest expenses at the fund level to borrow to cover any delinquent payments or may have to make additional contributions to cover any defaulted amount. These amounts may not be recovered from a transferee. The manager should review the fund documents, including any disclosure in the offering memorandum, to ensure the potential detriments have been disclosed to non-transferring investors.
- • Are there structural impediments to the transfer? Certain transfers may be logistically difficult or impossible to implement in certain fund structures. For example, a structure that restricts all tax-exempt investors to selling only to other tax-exempt investors may make it more difficult to market fund interests and may limit the transferees that can be admitted. Ideally, the flexibility has been built in to transfer commitments between fund vehicles in connection with a transfer.
- • Who will be liable for any clawback obligations? The transferee is typically responsible for meeting all capital call obligations, including those associated with an investor clawback (i.e., a recoupment of prior distributions to cover fund liabilities). In some cases, however, the transferor and the transferee may agree outside of the fund documentation, and without informing the manager, that the transferor will remain liable for these obligations. While the fund manager would ultimately have the legal right to recover from the transferee, there may be delays, enforcement costs and, potentially, damage to the manager’s relationship with the investor.
- • Who is the acquiring entity? A transferee may attempt to acquire a secondary interest through an entity that insulates the ultimate purchaser from liabilities associated with clawbacks or other unanticipated capital calls. In the current economic environment, fund managers must pay attention to the entity that is admitted to the fund as part of a transfer, and should consider requiring parent guarantees for the financial obligations associated with becoming an investor.
- • What representations will the manager have to give? Secondary investors generally conduct due diligence on funds and fund managers as part of their acquisition of a fund interest. Fund managers must balance their desire to facilitate a transfer with the need to protect themselves from potential liability. Managers should be particularly careful not to make representations regarding potential investor clawbacks or recycling provisions. In addition, sharing detailed information with a potential secondary investor that is not shared with all fund investors can create an information asymmetry between the selling investor and the secondary investor, as well as between the secondary investor and the other investors.
- • Are investors being treated fairly? When considering what action to take in a particular situation, a manager should take care to treat all defaulting investors fairly, to take actions that best fit the particular circumstances, to consider the precedent created by its actions and to consider the best interests of the fund and investors in evaluating default remedies. While different default situations may warrant different responses, investors may question why the manager handled one situation differently from another and a manager will want to avoid the appearance of arbitrarily imposing a harsher penalty on one defaulting investor than another. Some default remedies, such as the manager itself acquiring the fund interest from the defaulting investor may benefit the manager or the principals and give rise to the appearance of impropriety. The manager must take care to minimise, and appropriately address, any actual or perceived conflicts of interest.
While the current pressures on fund managers will soon pass, a similar economic cycle is likely to arise at some point in the future and managers can take steps now to ensure the transfer provisions in new fund documents reflect the lessons learned from the current economic situation.