ILPA guidance: Principles to consider for GP-led secondaries

As we enter Q3, it seems like a good opportunity to revisit the recently released Institutional Limited Partners Association (ILPA) guidance regarding continuation funds in the context of GP-led secondary transactions, particularly given the ongoing stream of questions we are fielding from fund sponsor clients.  Previously, my colleagues Isabel Dische and Robert Schmidt summarized some of the key elements of this guidance, which can be found here.

From our conversations, GPs seem to appreciate that ILPA guidance is by no means binding, but see it as a window into what their LP base may be looking for when a fund pursues a GP-led secondary transaction.

The primary questions from sponsors have been regarding the two general principles outlined by ILPA:

1. That a GP-led secondary transaction should “maximize value” for the existing LPs in the fund transferring underlying assets to the continuation fund; and
2. That those existing LPs who elect to maintain their exposure to the underlying assets (so called “rolling LPs”) should be “no worse” than they would be if the transaction at issue were not consummated.  

I will address these in turn:

The natural interpretation of “maximizing value,” at least at first blush, would be maximizing potential payout to those Existing LPs who choose to cash out.  That’s unlikely to be the intent, though.  If that were the case, many GP-led secondary would fail to maximize value since logic would follow that in most instances a buyer who is taking control of the assets would bid more than a buyer who is seeking only economic exposure.

Even within the context of evaluating letters of intent from bidders in a GP-led secondary, price isn’t the sole consideration.  Buyers frequently will speak to their experience in the market, their expectations for the deal and their ability to close and fund promptly.  These qualitative factors certainly have a role when determining which bid maximizes value for existing LPs.  And in the context of choosing between a traditional sale of the asset versus a sale to a continuation vehicle, the latter provides non-economic value in that it gives optionality to existing LPs that a traditional sale cannot provide.

The principle that rolling LPs should be “no worse” than they would be if the transaction at issue were not consummated also requires some context.  If zero downside risk were the threshold, most GP-led secondary transactions would violate this principle at the outset: a GP-led secondary transaction involves broken deal risk, just as any disposition does, so all LPs risk being in a worse position than if no such deal were consummated (both because of the broken deal costs and because of other potential exit opportunities forgone).

Rather, ILPA seems to be urging a status quo option.  ILPA stated in this guidance that any such deal should include a status quo option, which they describe as being a transaction in which the continuation fund does not subject a rolling LP to a higher management fee rate, stepped-up management fee base, higher carried interest rate, lower preferred return or crystallization of carried interest upon the transfer of a rolling LP’s interest to the continuation fund.

If a deal satisfies those criteria, the sponsor can make a reasonable argument that the rolling LPs are no worse than they would be in the absence of a deal.  Of course, circumstances of a specific deal can alter that conclusion.  To use an extreme example (and to be clear, not one we’ve ever seen actually proposed in a GP-led fund recapitalization), if the continuation fund were a general partnership rather than a limited partnership it’s fair to say that reasonable people would conclude that such deal leaves rolling LPs worse than they would be in the absence of a transaction, regardless of the economic terms.

A third principle in the guidance that has caught the attention of fund sponsors is the notion that expenses should be “allocated according to which parties benefit from the transaction.”  

The concern is twofold: how do we determine who benefited; and moreover, does this mean the allocation should be based on relative magnitudes of benefits (some of which are not quantifiable)? Certainly, the new investors in the continuation fund benefit from the deal. Selling LPs also benefit from the deal, since they have liquidity at a time when they otherwise would not.  

Do rolling LPs benefit?  That isn’t as clear of a case, although I would advise that the optionality provided is itself a benefit.  Has the sponsor benefitted?  It is hard to say the sponsor has not; but yet I do not see GP-led secondary transactions allocating a portion of the deal expenses specifically to the general partner or any other sponsor entity.

Practice points:  These principles I reference all are open to interpretation, but perhaps intentionally so.  The overarching principles to ILPA’s guidance appear to be that the sponsor should be mindful of the existing LPs’ interests when determining whether to engage in a GP-led secondary transaction and that the sponsor should involve existing LPs in the discussions to the extent appropriate.

I like to advise my sponsor clients that negotiations regarding GP-led secondary transactions involve three stakeholder groups – the sponsor, the new investors and the existing LPs – but only two parties have a seat at the table at all times: the sponsor and one or more lead investors acting on behalf of the new investors. 

The sponsor has an outsized role in determining the terms for the existing LPs. Take that role (and your fiduciary duties to the existing fund) seriously, and the sponsor is likely to have acted in a manner consistent with the principles in ILPA’s guidance.

Please get in touch if you have any questions relating to this ILPA guidance or would like further information generally.