United States: Secondary Market Advisory Newsletter – Fall 2018

Welcome to the Fall 2018 edition of the Duff & Phelps Secondary Market Advisory (SMA) newsletter. Enclosed you will find the names of private equity and hedge fund managers for whose funds Duff & Phelps holds current secondary market pricing indications. You will also find a Q&A with Ken C. Joseph, Esq. who shares his thoughts regarding the current regulatory environment as it pertains to GP-led secondary transactions.

Highlighted Content Includes:

• Private equity and hedge fund manager pricing list
• Recent Duff & Phelps advisory experience
• Navigating GP-led secondaries - Q&A with Ken C. Joseph, Esq.

Interview with Ken C. Joseph, Esq, Managing Director, Disputes and Investigations

Q: Recently, Europe has been one of the most active regions for GP-led secondary transactions. Are there any significant regulatory differences between Europe and the U.S. that may be holding back GP-led activity in the U.S.?

A: It is true that the secondaries market in general has experienced rapid growth over the last decade and that European GP-led deals have outpaced U.S. deals. I expect that the U.S. GPs will increase activity in the near term, probably driven by pressure from LPs as well as GPs' desire to provide liquidity for investors in funds that were formed in the wake of the financial crisis and which are approaching "zombie" status.
   
That said, there is no question that in recent years the U.S. securities law enforcement and examination environment has had an impact on the considerations that prudent GPs must factor into the equation when deciding whether to do secondaries, and when determining what form those liquidity events should take. In addition, spurred by heightened regulatory scrutiny and the lessons learned from some well-publicized enforcement actions, LPs are demanding more disclosures from GPs and are performing their own due diligence on the material terms of proposed deals. LPs are also not shy about contacting regulators when secondaries terms are perceived to be unfair, or when their own due diligence uncovers potential inconsistencies.
 
Q: Before launching an offering, what are some things GPs and advisors should keep in mind to help avoid post-transaction regulatory hurdles?

A: Because the U.S. Securities and Exchange Commission (SEC) does not pre-review or approve the terms of these private securities transactions, GPs and their advisoers should adopt a 'regulator's eye' and view the terms offered through the lens of an aggrieved LP. In assessing the risks of regulatory scrutiny, GPs should recognize that GP-led secondaries are inherently conflicted transactions, and they should ask themselves:

• What could be perceived as unfair to the client fund, or to the fund's LPs?
• Has the GP disclosed accurately and completely all material information so that LPs can make an informed decision?
• Has the GP identified all material conflicts—including financial incentives—and disclosed those conflicts to the client and to LPs? 
• Has the GP disclosed all material interests that the GP has in the outcome? 
• Has the GP favored any party to the transaction, and has the process been made transparent and legally compliant? 
• Have material terms, such as valuations, been determined after proper due diligence and with input from independent experts? 

At every level of inquiry, GPs/advisors should always remember that they are fiduciaries and are subject to the anti-fraud and other applicable provisions of securities laws.

Q: In a potential review of a GP-led transaction, are there any primary areas of focus for the U.S. SEC? If so, what are they?

A: Beginning in 2014, there has been an uptick in U.S. regulatory scrutiny on private equity funds, particularly on those engaged in transactions where there may be inherent conflicts, potential lack of parity of access to material information, and where there were concerns over adherence to fiduciary duty obligations to put the interest of the client fund and by extension investors in the fund above all else. 

Specifically, U.S. regulators have examined and investigated concerns that GPs may have:

• Operated funds beyond the expected end-of-life, without complying with notice and investor consent obligations reflected in fund documents
• Continued to collect management fees on "zombie fund" investments, with little incentive to wind-down those investments for the benefit of fund LPs
• Continued to collect monitoring and board fees, without determining whether winding-down those investments would better serve the interests of the fund and its investors 
• Sought to improperly extend the life of funds, or alter management fee and carried interest hurdles
• Made incomplete or inaccurate representations in solicitation documents 
• Withheld or used material non-public information in a manner that harmed client funds or LPs
• Failed to comply with U.S. securities tender offer rules (for deals involving tender offers)
• Improperly valued assets in secondaries
• Improperly collected fees from, or inappropriately shifted expenses to advised funds 
• Failed to offset certain compensation obtained as a result of the transactions 
• Improperly obtained transaction-based compensation, without complying with the broker-dealer registration requirements
• Made full and fair disclosures to client funds, or to investors in those funds; and 
• Otherwise breached obligations to non-selling LPs who remain invested in the fund

Q: To investors in private assets, the U.S. SEC's priorities can sometimes seem a bit inscrutable. How can investors in private assets best stay informed regarding relevant U.S. SEC actions and news?

A: Obviously getting advice and counsel from informed consultants and legal advisors is one way investors can stay current on the industry-specific risks and priorities of the U.S. SEC. In addition, the U.S. SEC has increasingly used a range of public platforms as part of its strategy to deter misconduct and encourage compliance with its rules and regulations. For example, investors should consider subscribing to:

• News announcements from the U.S. SEC (available here);
• Priorities and risk alerts (available here);
• Enforcement actions (available here);
• Periodic guidance (available here) and commission speeches (available here).

LPs employing this do-it-yourself approach may still need objective and informed guidance to put the U.S. SEC-provided information into context, to interpret the nuances and to assess how their particular set of facts and circumstances may be impacted by the Commission's pronouncements. 

Q: Are there any resources available to LPs to help them evaluate, from a regulatory perspective, GP-led transactions involving funds in which they are invested?

A: The U.S. SEC does not opine prospectively on the merits of GP-led secondaries. LPs therefore must either rely on GPs to act in the LPs' interest, or diligence the proposed deal themselves. While LPs may be eager to get liquidity for a variety of reasons, many may not have sufficient expertise onboard to properly diligence and evaluate the GP-led deals and may not even be familiar with the process sufficient to determine where interests may not be aligned. Under these circumstances, there is really no substitute for competent and informed legal and consulting advice from knowledgeable persons. Expertise in assessing the risks, costs, benefits, valuation, pricing and overall fairness of the proposed transaction is crucial.

Q: From a regulatory perspective, in what areas can an advisor add the most value in a GP-led secondary transaction?

A: As much as trusted, independent and knowledgeable advisors can assist LPs to diligence the proposed transactions, such advisors can add value and reduce the risks to GPs as well. GPs who want to get it right and minimize the risk of regulatory scrutiny or LP lawsuits can find value in employing independent, knowledgeable and conflict-free third-party advisors to help them navigate the complex world of secondaries. Regulators tend to get involved when things go wrong and to review actual or potential misconduct with a retrospective lens. If a GP finds itself in the regulatory crosshairs, the GP can bolster its defense by demonstrating that it took reasonable steps and followed proper procedures to diligence transactions, to value assets, to disclose material information and conflicts, and documented its adherence to the fiduciary and compliance rules. Doing so will generally help to demonstrate the GP's lack of malintent to breach its fiduciary obligations, assuming such failings even occurred.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.