Second spin

Julian Ashworth and Philip Millward of global law firm Walkers discuss the legal points to consider in secondary transactions.


After the anticipated explosion in the secondary market failed to materialise last year, several commentators believe that in 2010 expectation and reality will finally converge. If so, what high-level legal issues do prospective purchasers and general partners need to consider when contemplating entering or consenting to a transfer of a limited partnership interest?

2009 was characterised by yawning bid-to-offer spreads and an absence of distressed sellers flooding the market with assets to be liquidated at any price. Price spreads only started to narrow in the last six months of the year with research indicating average high bids were closer to 30 percent below net asset value as opposed to the dramatic 60 percent differential in the first half of 2009. Conversely, secondary fundraisings performed relatively well in 2009. A recent report from Dow Jones Private Equity Analyst noted secondary funds raised $17.5 billion in the calendar year, which was more than 80 percent higher than the previous year, and the only asset class to improve on 2008 fundraising efforts. 
With an increased pool of capital (buoyed by sovereign wealth funds earmarking capital for acquisitions in the secondary market such as China Investment Corp), narrowing price spreads, funds seeking liquidity or reducing overall exposure to private equity as an asset class and the spectre of regulation which may force banks to sell down or exit fund positions, 2010 may provide fresh impetus to the secondary market.  
One aspect of the secondary market, and the focus of this article, involves the transfer of a limited partnership interest from an existing limited partner in a private equity fund to another investor. There are a number of key high-level issues from a legal perspective that need to be considered by both investors and the general partner of the relevant partnership who will need to consent to such a transfer. Legal advice should be sought at an early stage.  
There are, of course, separate and additional issues to consider if a secondary direct, synthetic secondary or other type of secondary transaction is to be undertaken. These issues fall outside the scope of this article.
Investor concerns
When undertaking financial, commercial and legal due diligence, five key issues a prospective purchaser should consider are:
  • Encumbrances – A prospective purchaser should determine if a limited partner's interest in a partnership has been encumbered either by the limited partner direct or pursuant to the terms of any security arrangement in place with a lender or other creditor of the partnership.  
  • Rights of first refusal – Consider any pre-emptive rights set out in the partnership agreement that apply to the transfer of an interest in the partnership.  The seller and general partner will be required to work through such process, which may have cost and time implications. 
  • Capital calls and limited partner liabilities – Determine whether all capital calls have been fully funded and determine what distributions or other amounts are subject to recall by the general partner. The allocation of such liabilities, together with liability for clawback and indemnification obligations, should be set out and allocated in final form documentation entered into by the seller and purchaser (and/or otherwise factored into price).
  • Legal opinions – Review legal and tax opinions which have been prepared and issued in favour of the partnership and/or limited partners. Such opinions will typically confirm limited liability status of partners and other relevant tax matters in connection with the jurisdictions in which the Partnership has invested.
  • Side letters – A purchaser should consider obtaining consent of the general partner to the assignment of the benefit of any side letter provisions granted to the existing holder(s) of interests, including, for example, the benefit of most favoured nation or co-investment rights, proportional liability for fund of funds in the event of a partial default, and affiliate transfer rights.
General partner concerns
The general partner's written consent is invariably required for any transfer and generally may be withheld in its discretion (subject to agreed carve-outs in relation to, for example, affiliate transfers). Five key legal issues a general partner should consider when approached in connection with a proposed transfer include:
  • Non-disclosure agreement – Any prospective purchaser will invariably require information on the partnership's underlying performance which will raise confidentiality issues.  A non-disclosure agreement should be prepared in favour of the general partner and signed by the purchaser prior to the disclosure of any relevant information. The seller should also carefully review its confidentiality obligations under the partnership agreement, subscription agreement and/or side letters.
  • Rights of first refusal – As with a prospective purchaser, the general partner should consider whether there are any rights of first refusals or other similar pre-emptive procedures that need to be followed before consent can be given to the transfer of an interest to a third party.
  • Investor-specific issues – In addition to financial considerations (such as the ability of the proposed transferee to fund future capital calls and/or clawback and indemnification obligations), the general partner should consider whether any regulatory or other investor-specific representations or opinions should be sought by way of the transfer documentation (such as ERISA confirmations).
  • Conflicts/advisory committee issues – Although conflicts rarely arise in the context of genuine secondary transactions, the general partner should consider the extent to which advisory committee consents may be required if the proposed transferee is an affiliated entity or successor fund.  
  • Regulatory issues – The general partner should consider whether a transfer will trigger any legal or regulatory issues, for example whether a fund could become classified as a “publicly traded partnership” under US securities laws if it does not otherwise fall within one of the relevant safe harbours.  
As identified above, there are a number of hurdles and potential pitfalls to safely navigate, and transactional parties should involve offshore counsel at the outset of the sales process of an offshore partnership interest (or other secondary transaction).  
Philip Millward is a partner and Julian Ashworth is an associate with Walkers' private equity group in the Cayman Islands.