In this Ropes & Gray podcast, asset management attorneys Lindsey Goldstein and Kevin White discuss some of the approaches taken to build authorities into fund limited partnership agreements to allow for future alternative liquidity opportunities. They discuss some considerations sponsors and investors should consider when negotiating these authorities, including what sponsors should keep in mind when determining whether to attempt to build in these authorities.
Lindsey Goldstein: 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 Lindsey Goldstein, a partner in our asset management group based in New York. Joining me today is my colleague in San Francisco, Kevin White. Today, we are going to be talking about “pre-baking” authorities for alternative liquidity solutions into fund LPAs.
Kevin, do you want to kick off our discussion?
Kevin White: Sure. Sponsor appetite for alternative liquidity solutions, and investor appetite for providing such liquidity opportunities, have exploded over the last several years. Primary examples of these types of solutions are GP-led secondaries, preferred equity stakes and NAV loans, but they also can include similar transactions such as tender offers. These types of deals necessarily require the sponsor to look back at fund documents, namely fund LPAs, drafted years ago to see whether the necessary authorities and plumbing for these transactions are there; they also are looking at what procedures or approvals they need to do these transactions. Many of these sponsors simultaneously are out fundraising for new flagship vehicles. With that context, it shouldn’t be a surprise that we are starting to see sponsors wanting to “pre-bake” consent for transfers of assets to continuation vehicles, authorities for NAV loans, and similar authorities into the fund LPAs for their current fundraises so as to get ahead of these issues.
Lindsey Goldstein: That’s right, but that itself creates a host of issues for sponsors. It’s also a matter that investors—both investors negotiating the liquidity transactions and investors in the fundraises—will care about and want to negotiate.
Taking primary fund investors first, those LPs typically will want guardrails around the fund terms to ensure that their investment won’t be diluted or subrogated. They also will be reluctant to pre-approve an inherently conflicted transaction for the GP where the terms of that hypothetical future transaction are unknown. Very bluntly, many LPs will resist providing such approvals in advance, at the time of the initial fundraise.
By contrast, preapproval provisions will typically be viewed more favorably by secondary buyers. From the perspective of a secondary buyer or an investor providing preferred equity financing or a NAV loan, it will be key to confirm that the underlying fund has authority to engage in the proposed transaction. What that authority must cover will depend on the parameters of the proposed transaction. For example, in a preferred equity deal, the secondary buyer likely will want to see that the fund LPA allows for new classes of interests that have different economics.
Secondary buyers will not want to take risks around a fund’s ability to engage in a transaction. Having the underlying fund’s LPA either preapprove the transaction or specify a reasonable mechanism for obtaining such an approval is a way to mitigate execution risk. That said, secondary buyers may be nervous about relying upon a preapproval of a transaction where the LPs did not have fulsome disclosure over the contours of the transaction, ultimately asking: Can a consent be valid if the LPs did not have visibility on what was being approved?
For these reasons, so-called “preapproval provisions” may be more helpful to the extent they introduce the concept of a future transaction, rather than attempt to seek consent for any particular transaction, which we will touch on later in this podcast.
Kevin, what kind of modifications are you seeing to accommodate preferred equity or NAV loans?
Kevin White: NAV loan authorities are pretty straightforward. The most common structure for a NAV loan is the transfer of portfolio company assets to a subsidiary vehicle, which then would use those assets as collateral for the NAV loan. In order to bake this into the fund LPA, the sponsor would treat the subsidiary as a “portfolio company” for purposes of the fund LPA but exclude it from the concentration limitations and other investment limitations associated with portfolio companies. The sponsor also would exclude the subsidiary’s indebtedness from the limit on fund-level borrowing. Investors will want some assurance that the sponsor won’t use this authority to leverage to the hilt. One way to mitigate this is to require that any NAV loan arrangement receive the consent of the fund’s LPAC.
Pre-baking authority for pref equity is a much steeper climb. In this instance, you are asking LPs to agree now that their entitlement to distributions may be subrogated later. That, of course, is a very hard sell. It’s worth determining whether the juice is worth the squeeze over a deal that may never happen anyway. The alternative is for a sponsor to hold off on including these authorities at the outset and then amending the fund LPA in connection with a deal at a later date. There’s deal execution risk involved with that approach, but it may be worth taking that risk in order to avoid negotiating the issue with fund investors at the time the main fund terms are being negotiated. That risk also can be mitigated through communication with LPs as a sponsor begins to explore a potential preferred equity financing.
Lindsey, what do you see being built into fund LPAs regarding future continuation vehicles?
Lindsey Goldstein: When sponsors attempt to pre-bake authority for a GP-led secondary, I normally see it reflected in the fund LPA as some flavor of consent to disposition of portfolio companies to a continuation vehicle. But rarely would you see a consent that strong ultimately live through LP negotiations, for obvious reasons: How do investors get comfortable consenting today to a deal some day in the future involving portfolio companies that haven’t yet been acquired, for a price that hasn’t yet been determined and on terms that haven’t yet been fleshed out?
It’s very difficult to get a full-fledged consent now; moreover, there is no assurance that such a consent would pass muster with an SEC that wants to see that investors are given the material details in a GP-led secondary and have a chance to provide an informed consent to the transaction. But even conceding all that, there’s still good reason for sponsors to want to build in some early flexibility around the concept in the fund LPA, for instance, by pre-baking the ability to make non-pro rata in-kind distributions in the event of a continuation fund transaction. This is something we’ve seen LPs ultimately be okay agreeing to at the outset, and for the sponsor it alleviates the need for down-the-road amendments to the LPA to make these distributions. And by introducing the concept at the outset, the sponsor has an opportunity to have discussions with LPs about these potential transactions early-on. For the investors, it’s an opportunity to get sponsors on the record that they would seek LP or LPAC consent, or at the very least a fairness opinion, in connection with any disposition of portfolio companies to an affiliated vehicle.
Kevin White: I think this leads to a fundamental question that sponsors and investors need to consider. If you’re in the midst of a fundraise and you introduce some terms in your fund LPA regarding a future liquidity transaction, are you willing to engage in a simultaneous negotiation of your flagship fund terms and of potential CV or borrowing sub terms for vehicles that may never come into being at all? That’s a lot to negotiate now. And from the perspective of the investor, are you willing to fund an investment as well as put your cards on the table regarding future liquidity terms right now?
Needless to say, there isn’t a clean answer as to whether a sponsor should push for these authorities in a fund LPA during the fundraise, and there isn’t a clean answer as to whether investors should entertain the discussion. From the sponsor’s perspective, it’s more likely to be worth the negotiation if the sponsor is highly convicted that GP-led secondaries, pref equity or similar transactions will occur. From both the sponsor’s perspective and the investors’ perspective, the discussion is more likely to be productive if the parties have a longstanding relationship.
Lindsey Goldstein: Thank you, Kevin, for joining me today for this discussion, and thank you to our listeners. For more information on the topics that we have 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’ve 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 and Spotify. Thanks again for listening
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