In this Ropes & Gray podcast, asset management partners Adam Dobson, Isabel Dische and Lindsey Goldstein discuss fund recapitalization transactions and a recent trend by some sponsors toward pursuing these transactions without a lead secondary buyer, and certain key risks for both fund sponsors and secondary buyers.
Adam Dobson: 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 Adam Dobson, an asset management partner based in our Boston office. Joining me today are my New York-based partners Isabel Dische, who co-heads our institutional investor practice, and Lindsey Goldstein. Today, we are going to be talking about fund recapitalization transactions and, in particular, a recent trend by some sponsors toward pursuing these transactions without a lead secondary buyer.
Isabel, would you like to kick-off our discussion with a quick overview of who the typical players in a fund recapitalization transaction are and what we’ve seen change in a few deals recently?
Isabel Dische: Gladly. In your typical fund recapitalization transaction, a fund sponsor sells one or more assets from an existing vehicle to a continuation fund that is capitalized by one or more secondary buyers. While the continuation fund is controlled by the same sponsor, the pricing and terms of the transaction are typically negotiated as between the lead secondary buyer or buyers and the fund sponsor on behalf of the existing fund. In recent months, however, we have seen a few fund sponsors take a slightly different approach—rather than solicit interest from potential buyers to be lead and then negotiating the terms of the deal with that winning buyer, a few sponsors have shifted to soliciting interest from secondary buyers in a fully baked deal, the terms of which are fully set by the sponsor itself rather than negotiated by a lead buyer. To be clear, this approach remains a very uncommon one—and most deals are still being actively negotiated by a lead secondary buyer. That said, there are some important implications for both fund sponsors and secondary buyers, as they consider participating in a sponsor-negotiated fund recap. From the perspective of the fund sponsor, it may seem simpler to negotiate the deal without involving the lead buyer. The approach carries added risk for the sponsor, however, as it loses the third party benchmark upon which the sponsor’s relying to set the price at which the cross trade between two funds is effectuated.
Lindsey Goldstein: Yes. That conflict is a real concern for a fund sponsor and it’s worth noting that the SEC Staff has in the past identified the inherent conflict in fund recap transactions as an area of interest. In the absence of a third party-set price, a sponsor will want to think about ways to support its conclusions that the price and terms of the proposed transaction are fair to investors on both sides. A sponsor may want to consider seeking a fairness opinion to support the pricing (and if it is having a new vintage fund participate alongside the secondary fund, it may want to have two fairness opinions—one for the selling fund and one for the buying vehicles). The sponsor also will want to be thoughtful about the terms of the deal—both in terms of how the assets are being moved from the selling fund to the buying fund and any ongoing liabilities and indemnity obligations of the selling fund, and in terms of what options are being offered to investors in the selling fund (e.g., is there a status quo roll).
Adam Dobson: The heightened conflicts in these transactions also have implications for secondary buyers, as not only do they need to be comfortable that the transaction process won’t be disputed—as secondary buyers in general are loathe to be associated with a fund recapitalization transaction process that is viewed as problematic—and they should be aware that some of the steps sponsors take to alleviate the conflict in the absence of a third-party negotiated deal may result in added costs and/or terms that differ from what a secondary buyer might have negotiated. For example, secondary buyers typically would not ask for a fairness opinion as they undertake their own diligence in deciding whether to pursue a recapitalization transaction, yet sponsors are more likely to try to split the costs of a fairness opinion (or opinions) across both the selling and the buying vehicles in sponsor-negotiated fund recapitalization transactions precisely because the sponsor doesn’t have a third-party buyer. The implications for secondary buyers of participating in a transaction without a lead buyer resonate even beyond questions such as their potentially paying a larger portion of, and different quanta of, transaction expenses. The lead buyer typically has an active role in assessing whether closing conditions have been satisfied, waiving compliance with certain pre-closing covenants and, post closing, ensuring that the continuation fund’s indemnity rights are enforced as necessary. In the absence of a designated lead buyer, secondary buyers are exposed to heightened uncertainty around each of these points and, in particular, to heightened risks stemming from the sponsor’s role on both sides of the deal.
Lindsey Goldstein: Needless to say, from the perspective of both a fund sponsor and a secondary buyer, a sponsor-negotiated fund recap carries real risks that should be considered with care. Thank you, Adam and Isabel, for joining me today for this discussion, and thank you to our listeners. 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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