Podcast: A Primer on Fund Recapitalizations
In this Ropes & Gray podcast, asset management and tax attorneys Isabel Dische, Lindsey Goldstein, Dan Kolb, Alex Chauvin and Jessica Marlin discuss fund recapitalization transactions, including what these deals are and why a fund and its limited partners may want to pursue a fund recap. This episode also touches upon typical structures for these deals and certain considerations fund sponsors will want to keep in mind, as well as how to reduce deal execution risk.
Isabel Dische: 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 Isabel Dische, a partner in our asset management group based in New York, and co-head of our institutional investor practice. Joining me today are my asset management and tax colleagues, Lindsey Goldstein, Jessica Marlin, Alex Chauvin and Dan Kolb. Today, we are going to be talking about fund recapitalization transactions. We’ll start with a brief explanation of what these deals are, and why a fund and its limited partners may want to pursue a fund recap. We’ll next discuss typical structures for these deals and certain considerations fund sponsors will want to keep in mind, as well as how to reduce deal execution risk. Finally, we’ll quickly cover certain key tax considerations in these deals.
Jessica, would you like to kick off our discussion with a quick overview of what exactly a fund recap is?
Jessica Marlin: Happy to. Very briefly, in a fund recapitalization, a sponsor sells some or all of its investment in one or more portfolio companies to a continuation vehicle that is managed by the same sponsor, but capitalized by a new investor base. Existing investors typically are given the option of either cashing out all or a portion of their indirect interest in the asset or continuing their investment through a new continuation vehicle. That continued participation can be structured either as a “roll” or as a “reinvest.”
These transactions can be attractive for sponsors and investors for a range of reasons. For example, a sponsor may have a firm conviction in a longer-term value creation thesis, but if the assets have already performed well and appreciated in value, fund investors may want to cash out. A fund recap can allow the sponsor to retain the exposure to the assets they like while giving a nearer-term liquidity option to interested investors. (This can be particularly relevant under choppier market conditions, where sponsors may worry that the market isn’t properly valuating an asset.) Alternatively, one or more of the assets may require more follow on capital and/or a longer realization timeline than is available within the existing fund, and a fund recap, again, provides a mechanism for the sponsor to access that capital and additional time.
Lindsey, do you want to discuss the legal and other considerations?
Lindsey Goldstein: As Jessica noted, there are a number of compelling business reasons that may prompt a sponsor to pursue a fund recapitalization. There are, however, some considerations that sponsors will want to keep in mind. First and foremost, because these transactions involve selling an asset from one of the sponsor’s funds to another (and where the sponsor may receive additional fee and carry streams from the continuation fund), the sponsor will want to carefully navigate the conflicts of interest inherent in these deals. Depending on the terms of the existing fund’s LPA, the sponsor may need to go to the full LP base for approval or may be able to have the conflict blessed by the LPAC.
A sponsor also will want to check whether any other approvals are required—for example, under individual investors’ side letters or under the terms of the underlying asset’s shareholders agreement or other governing documentation.
Another consideration relates to the presence of any existing coinvestors. In particular, depending on the terms of any coinvestor arrangements, the sponsor may or may not be able to drag coinvestors in the transaction, or coinvestors may have tag rights. Sponsors’ views of coinvestor participation in the recap also may depend on the particulars of the transaction. For example, if there is limited capacity on the buy side or if there are concerns about deal complexity or timing, a sponsor may prefer not to give coinvestors the option of selling in the deal. Conversely, it may be that a secondary buyer has indicated it wants a larger exposure to a particular asset, motivating a sponsor to find a way to offer liquidity to those coinvestors. Relationship factors—and the document terms—will all play a role.
That brings us to the question of the typical deal process for one of these transactions. As a first step, a sponsor typically will engage a placement agent to solicit interest from secondary buyers. Isabel, do you want to speak to the auction process and what considerations are top of mind for secondary buyers?
Isabel Dische: Certainly. Just to say it, in the first instance, sponsors also will want to evaluate whether to sell one or more of the assets outright as compared with pursuing a fund recap. The pool of potential buyers will be different for a recap than for an outright exit, as typically these deals have been the domain of secondary buyers as compared with other sponsors and corporates. The deal size—whether too large or too small—may further limit interest even amongst secondary buyers.
Much as with the process for selling an asset to a third party buyer, the sponsor’s agent will solicit interest from a number of secondary buyers in the first instance. With the diligence and bidding process, the pool of interested buyers will likely shrink. Having some level of communication with the fund’s LPAC at each stage of the bidding process can help make sure the direction of deal structures and pricing being discussed are within the bounds that the LPAC supports, helping with deal certainty. So, what can go wrong?
Alex Chauvin: Sponsors and the secondary buyers who capitalize the continuation fund need to navigate pricing dynamics. If they set the price too low for high quality assets, too few of the existing LPs may cash out their interests. Too high a price, and a fund sponsor may deter potential buyer capital and may find itself without a deal or with a deal that is only partially underwritten, meaning that there isn’t enough buyer capital to buy out all of the LPs who want to sell.
To avoid a partially-underwritten deal (which, not surprisingly, tend to be less popular with investors) a sponsor may solicit buyer dollars from a buyer syndicate and may also offer its existing investors the ability to invest in the continuation fund directly (versus only rolling their interest).
It is worth noting that secondary buyers also want comfort on deal size, however. So, even if a buyer might be able to underwrite a full deal, it may prefer to maintain a lower overall exposure. Both to address buyers’ desire to limit their overall concentration and to allow funds and buyers to line up sufficient capital, we often see parties agree to have a syndication window after investors have delivered their elections to sell or roll.
Jessica Marlin: Thanks, Alex, for describing what may go wrong. Key to navigating these issues from a sponsor’s perspective is communication with the LPAC and existing limited partners. We recommend that a fund keep the LPAC informed throughout the deal process, including explaining the decision to pursue a fund recap and soliciting feedback on key terms of the transaction—this is to avoid a mismatch between the negotiated terms and what the LPAC views as acceptable. After the terms of the transaction are negotiated with the secondary buyer, the sponsor will want to adequately disclose those terms of the proposed transaction to investors, including giving existing investors access to comparable materials as those that were provided to the secondary buyer. A sponsor will also want to ensure that its investors have adequate time to evaluate whether to sell or roll—typically at least 20 business days, although the tender period may need to be extended under certain circumstances.
Depending on whether the lead buyer is fully underwriting the transaction or not, the sponsor may also need to cooperate with the lead buyer to syndicate additional buyer commitments to acquire the full amount of interests tendered. All in all, the timeline for one of these deals can range from a few months to much longer.
Alex, do you want to highlight some of the economic and other key business items that we often negotiate in these deals?
Alex Chauvin: Of course. There are two key agreements in these transactions: The limited partnership agreement of the continuation fund and a contribution (or purchase and sale) agreement pursuant to which the assets are transferred from the existing fund to the continuation fund. Within the partnership agreement, the parties negotiate the key economic provisions, which are management fees and the carry waterfall, as well as how to handle follow-on commitments and expenses, dilution if existing investors do not have the same proportion of follow-on capital as the secondary buyer, governance, etc.
The contribution agreement (or purchase and sale agreement) serves to transfer the assets from the existing fund to the continuation fund. It makes clear exactly what assets and obligations are being transferred (and which are not), contains a variety of representations regarding the transaction and the underlying assets, and sets forth the negotiated indemnity package for the deal. While the contribution agreement is formally between the continuation fund and the existing fund, the lead secondary buyer(s) will be intimately involved in its negotiation.
One thing to note is that these deals can be very tax-intensive as, among other things, funds may try to structure these deals to effectuate the roll on a tax-free basis, and buyers may want to optimize how the asset is held based on their own tax status. Dan, do you want to highlight some of the potential tax considerations with these deals?
Dan Kolb: Sure. There are many tax considerations in these deals, and the relative importance varies depending on the facts. On the fund sponsor side, among other items, if the sponsor is rolling any portion of its interest, the sponsor will want to preserve tax-free treatment. The sponsor will often also try to provide rolling investors with tax-free treatment and to segregate rolling and selling investors so as to avoid accidental allocation of seller’s gain to the rolling investors. Further, in such transactions, a great deal of effort is invested in limiting withholding liabilities for ECI and FIRPTA. Due to the broad nature of the ECI withholding rules, investors with no ECI at all can easily be picked up. Sponsors must also consider how and whether to block ECI assets, and whether to sell blockers or the underlying assets. Among other items, buyers will focus on avoiding any assumption of seller liabilities (including partnership audit liabilities and any ECI withholding liabilities) and will consider 754 and 6226 elections to step up the acquired basis and push out historic audit liabilities. There are many other tax considerations, and these deals often involve many, many steps.
Isabel Dische: Needless to say, there’s a lot to consider, but fund recapitalizations can be attractive from the perspectives of fund sponsors, fund investors and secondary buyers alike. Thank you, Jessica, Lindsey, Alex and Dan, 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 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.