How antitrust issues could play out in the continuation fund market

Sponsors or GP-led secondaries processes should take care in the language they use to explain why they want to hold an asset for longer, writes Thiha Tun, a partner at Dechert.

Following a surge in post-pandemic deal activity, 2022 has shone an unprecedented spotlight on the private funds industry.

The US Securities and Exchange Commission has introduced a slew of new rules under The Investment Company Act of 1940 (“the 40 Act”) to increase regulation of investment managers. These represent the most significant attempt by an emboldened SEC to regulate fund managers. The rules apply not only to SEC-registered advisers but also to unregistered and foreign advisers relying on the “exempt reporting adviser” exemption, making them wide ranging and with extra-territorial effect.

On top of this, the US Department of Justice has stated it is committed to “aggressive” action against private equity firms’ violation of antitrust laws, particularly in the healthcare sector. Not to be outdone, the Federal Trade Commission also announced it will take a “muscular” approach when considering antitrust issues on private equity deals.

The private equity industry has not faced this level of scrutiny from three regulators with real teeth for decades.

Why should sponsors of GP-led secondary deals care, and what are the risks?

The SEC has explicitly said it believes that secondary transactions raise certain conflicts of interest and that GPs should take certain prescribed steps to identify and mitigate these conflicts. As GP-led secondary transactions get more complex, conflicts of interest arise at a number of levels, and not just with the GP. Effective analysis, identification and mitigation of conflicts are key to a successful transaction.

The number and size of single-asset GP-leds has increased significantly since the pandemic. One common rationale for GPs to put forward a continuation vehicle transaction is to continue growing an existing successful asset through roll-ups and follow-ons, etc. The use of ‘red flag language’ in deal documents makes great evidence for the FTC and DoJ when they try to block mergers that they consider anti-competitive. Thus, there is a higher degree of risk when GP’s use phrases such as “barriers to entry”, “limited number of competitors”, “sticky customer base” and “dominant player” to support their rationale for continuing to hold an asset for further growth.

In the buyout segment of the GP-led sector, portfolio companies of ever larger sizes are being transferred to continuation funds, and growing them through ‘roll-up’ acquisitions or mergers could trigger more substantive antitrust issues than a standard HSR filing.

Here are some of the consequences for GPs if they get it wrong:

1. An SEC investigation and fines for breach of fiduciary duties and breach of the new rules.

2. Inadequate resolution of conflicts of interest leading to a GP-led secondary transaction possibly having to be unwound. This could potentially develop years after the closing date, since anti-competitive behavior will take time to become apparent – not to mention the all the complexity and cost associated with an unwind (assuming it can even be done).

3. A DoJ or FTC finding, potentially years after the closing date of the secondary transaction, that add-ons have been in violation of antitrust laws and a resulting block on future roll-ups/mergers, leading to the asset not performing as predicted and investors being disappointed with lower returns.

4. Reputational damage to the GP, thus hindering future fundraising and causing loss of confidence by existing LPs and any potential new LPs.

The combination of seasoned GPs transacting deals under ever quicker timelines, the increasing complexity of deals, and new entrants entering the market but lacking a track record and experience, could result in a lack of due consideration for the SEC’s new rules and stance of antitrust regulators. As a result, this could lead to enforcement actions from the SEC, FTC and DoJ – the worst nightmare for private fund managers.

What can GPs do to mitigate risk?

Faced with the above, there are some key steps GPs can take to help mitigate risks.

First and foremost, familiarize yourself with the new SEC rules and understand the issues and industry sectors that both the DoJ and FTC have said they are most concerned about, for example, healthcare.

Make sure to assess whether assets are close to thresholds that would lead to antitrust/merger clearance filings needing to be made, and seek expert advice where appropriate. Ask legal counsel to review documents, whether legal or otherwise, for any potential ‘red flag language’ that could be jumped upon by the regulators, and consider early on whether to seek a fairness opinion from an independent expert.

Finally, GPs should robustly analyze potential and actual conflicts of interest, take steps to mitigate them, and seek LPAC waiver of conflicts. Transparency is key; consider seeking even LP consent for the secondary transaction as a whole.

The post-pandemic recovery has, so far, been hugely positive for the GP-led secondaries market. Although there is a trio of regulatory scrutiny bearing down on the industry, if GPs adhere to the steps above, there is no reason why this success cannot be continued into the latter half of 2022 and beyond.

Thiha Tun is a partner at Dechert focusing on private investment funds. He advises alternative asset fund sponsors, institutional investors and financial advisors on a broad range of issues, including fund formation and capital raisings, fund investments, GP and LP-led private equity and private debt secondaries transactions.