In this Ropes & Gray podcast, asset management partners Isabel Dische, Adam Dobson, Chune Loong Lum and Vincent Ip, and tax partner Dan Kolb share key trends and developments from the 2020 secondaries market and what secondary buyers, sellers and fund sponsors can expect in 2021.
Vincent Ip: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on topics of interest for asset managers and institutional investors. I’m Vincent Ip, a partner in our asset management group based in Hong Kong. Joining me today are Isabel Dische, Adam Dobson and Chune Loong Lum, fellow asset management partners based in our New York, Boston and Hong Kong offices, as well as Dan Kolb, a tax partner based in our New York office. Today, we are going to be looking back at key trends and developments from the 2020 secondaries market and what secondary buyers, sellers and fund sponsors can expect in 2021.
Adam, would you like to kick-off our discussion?
Adam Dobson: Gladly. COVID-19 and the related market disruptions were, not surprisingly, the most notable development in the secondaries market last year. After a very robust first quarter, secondary transactions came to a rapid halt in mid-March when economies shut down. We saw a number of deals—both fund recapitalizations and portfolio sales—fail as buyers and sellers reassessed whether the valuations on which they’d based their pricing were stale. Where deals weren’t abandoned, we saw pricing renegotiated, particularly where the buyers were concerned about the underlying portfolio’s resiliency to COVID-related market disruptions.
Vincent Ip: For the first time in a decade, we also found ourselves fielding questions about including MAC clauses in purchase agreements, although in our experience most buyers ultimately didn’t go down that path (in part based on observations of how challenging it is to rely on a MAC clause to get out of a signed agreement). Many buyers instead stepped aside from the market for a few months while they reassessed their existing portfolios and reworked their internal price models.
Chune Loong Lum: There are a few areas where we saw deals proceed, notwithstanding COVID. For example, in Asia we saw some sponsors pursue, and in some cases, successfully complete, significant strip sales and fund recapitalizations. Investors were willing to pursue these deals, market volatility notwithstanding, because the underlying managers and portfolio were viewed to be of high quality. In addition, because investors continue to show much appetite for investing in Asia, regional managers and emerging managers have also tried to take advantage of this trend by using secondary market portfolios as a staple to primary fundraises.
Many sponsors considered preferred equity financings as a way to access added capital for portfolio companies that needed more liquidity than the sponsor’s fund could otherwise support. In many cases, sponsors concluded the financing was too expensive to make sense as compared with other alternatives, but even still we saw a number of these deals papered in the second quarter, including transactions where the sponsor was using the preferred equity to finance an expanded GP commitment to its fund.
We also saw a number of large preferred deals involving portfolios of fund interests. In one of our podcasts from last year we discussed some of the reasons why both fund sponsors and investors might find preferred equity deals attractive.
Isabel Dische: While most of the secondary market paused its activity during the second and third quarters of 2020, a few subsets of the market remained active. For example, we saw a number of very large—multi-billion, and in one case multi-tens of billions—deals by sovereign wealth funds that were rebalancing and restructuring their portfolios. A transaction’s fate also depended on the underlying industry – for example, while deals with oil and gas exposure fell apart, several transactions with a health care focus proceeded to sign and close notwithstanding the COVID-related shutdowns and choppier market conditions. Another asset class of growing interest to secondary buyers was credit, and we saw a number of buyers pursue credit-related deals, such as setting up funds focused on acquiring portfolio company debt or setting up a continuation fund to buy discrete credit assets.
By the third quarter, fund recaps had reemerged with a roar alongside the reemergence of M&A markets more generally, and a number of blue chip sponsors pursued single asset deals, classic fund recapitalizations and even deals involving multiple vintages of funds. There were stretches of the fourth quarter where we saw billion dollar-plus deals signed daily. These deals were across asset classes and industries, including not only private equity assets, but also real estate and infrastructure funds. Many of these transactions involved a single underlying asset or had a large portion of the portfolio’s value concentrated in a single asset. Especially in the United States, many sponsors were very focused on closing their transactions before year end to avoid increases in tax rates that were anticipated with the change of administration.
Dan Kolb: Speaking of tax, a key development in the United States was the finalization of the ECI withholding rules. Due to an unfavorable court ruling in 2017, the U.S. government amended section 1446 of the Internal Revenue Code to clarify that the sale of an interest in a partnership with a U.S. trade or business by a non-U.S. seller was taxable and to impose withholding requirements on the buyer and underlying fund with respect to partnership interest transfers. In the latter part of 2020, the Treasury Department released final Treasury regulations that provide substantial guidance with respect to the application of these rules. Due to the broad nature of the new ECI withholding rules, you should not assume that these rules will only apply in appropriate cases. Instead, the new regulations generally require withholding whenever the buyer or underlying fund cannot, or in the case of underlying funds will not, provide appropriate certificates. As an example, while many sellers will be able to provide an exemption certificate based on the representation that their last three K-1s from an underlying fund reflect minimal or no ECI, if the underlying fund has not existed long enough to provide the seller with three K-1’s, or the fund has such limited contact with the United States that it does not issue K-1s, this exception does not apply. While funds can also provide exemption certificates, it is very unclear whether underlying funds will be willing to issue such certificates as a general matter for classic secondary transfers. Some funds have started issuing such certificates to a few very large investors, but historically funds have not provided much assistance for secondaries and we will need to bit of a culture shift before investors can rely on funds in this context. This shift may come in 2022. The regulations provide that in 2022, funds will have a withholding obligation on the buyer if the buyer did not properly withhold on the seller. This fund withholding obligation will force funds to increase their involvement in transfers and create a bit of fear in the buyer community. Finally, it is worth noting that while these rules impose a 10% withholding requirement, 10% of a $100 purchase price may not be $10. Instead, the 10% test is applied to the “amount realized,” which includes a partner’s share of fund debt. As a result, it is quite hard to figure out how much to withhold in cases where withholding is required. The Treasury Department has helpfully clarified that the buyer need not withhold more than 100% of the purchase price.
Isabel Dische: So 2020 is now behind us and already in 2021 we’ve seen a number of new secondary processes kick off, for portfolio sales, preferred deals and fund recapitalizations. Looking ahead, Vince, what do you predict for 2021?
Vincent Ip: Looking ahead, in the Asian market I’d expect more activity in the fund restructuring space as compared to years past. There was a significant drop in PE deal exits in 2020, which has resulted in the accumulation of assets and the need to generate distributions, whether to facilitate new fundraising plans or to right-size a large portfolio. Strong GPs who would otherwise have looked to trade sales or IPOs for liquidity may also test the secondary markets. There were quite a few single asset deals in 2020 and we expect to see more this year in Asia.
The pace of recovery in Asia will vary across regions because countries have experienced the effect of COVID-19 in many different ways. China will feel much more like business as usual whereas other parts of Asia will not. In China, classic LP secondaries involving Renminbi-denominated fund interests are very difficult to do, but there is a growing sector of the market where investors are willing to engage in complex GP-led deals involving the restructuring of Renminbi-denominated assets into portfolios held by U.S. dollar funds.
I also predict continued robust activity among the mid-market buy-side community in Asia, many of whom are local specialists who pursue single LP positions sourced through their own networks without the use of agents. They will also continue to participate in GP-led transactions, which may involve more closely-held portfolios managed by more local, and less-established managers.
Adam Dobson: In the U.S. and European markets, we’d seen a rebound in fund recapitalization activity toward the end of 2020, but going into 2021 it looks like deal activity is picking up across the secondary market. For example, as compared with historic rates, a disproportionate number of the ‘vanilla’ secondary sales that we saw toward the end of 2020 were privately arranged. LPs and buyers seem to be getting more comfortable with valuations, and going into 2021, we are aware of a number of large, brokered processes. One point that remains to be seen is whether we’ll continue to see the comparatively broader ranges in bids for interests that we saw last year (a factor that resulted in many of the portfolios that were sold last year being divided across more buyers as compared with historic trends in order to optimize overall price).
Vincent Ip: Needless to say, there’s a lot to consider, but it’s fair to say we predict 2021 will be another active year for secondary transactions, and sponsors and secondary buyers will continue to find creative ways to create alpha through these deals. Thank you for joining all of us for today’s discussion. For more information on the topics that we discussed or other topics of interest to the asset management industry, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we discussed – please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
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