In recent times, a cocktail of ample, free money and limited to no return on the fixed income markets, drove investors in search for yield towards private equity. These private equity funds typically have a lifespan of around 10 years. While, again in recent times, sales of portfolio companies was not a big issue considering valuations went up, taking into account the following:
However, the picture now is completely different with an economy facing difficulties, amongst others, due to:
This resulted in the worst 6-months period (January – June 2022) on the stock market (a leading economic indicator) since the financial crisis back in 2008. Therefore, an IPO is a less attractive option. Moreover, overall, valuations faced a correction.
Therefore, given the rather strict lifespan of a private equity fund, these funds looked for other options. Rather than to sell under duress to another party, or to opt for an IPO, an increasing number of private equity funds decided to go for a GP-led secondary, i.e., umbrella term which refers to a liquidation transaction triggered by the general partner (“GP”) of the private equity fund. These transactions allow the GP to continue to manage the portfolio company, while obeying to the terms and conditions of the initial private equity fund by delivering a return to the investors. A common GP-led secondary is the establishment of a continuation fund which purchases one (typically the crown jewel of the fund) or more assets (i.e., portfolio companies), thus providing a liquidity option, i.e., cash-out on the fund, or invest in the secondary fund.
While in theory, this is a win-win for both GP and investors, in practice these kind of transactions result in a conflict of interest. Indeed, it could be more interesting from a GP perspective to deflate the value of the portfolio assets, specially if the initial fund will pass the pre-agreed return (8% on average) and thus will pay out carried interest to its GP (vice-versa, it can be interesting to inflate the value to receive carried interest). By doing so, GPs can make sure to receive carried interest (potentially twice) as well as charging management fees as a proportion of the amount it invested in a company – which will invariably be a higher amount than the initial fund paid1.
Due to this conflict of interest, the Securities and Exchange Commission (“SEC”) is scrutinizing the model and is planning to require a fairness opinion when a fund sells to themselves. It is not clear whether the Belgian Financial Services and Markets Authority (“FSMA”) or EU are planning the same.
However, for both GP as well as investors alike, a fairness opinion is highly recommended to ensure transparency and decrease the exposure to risk of conflict of interest.
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Kenny Van Tulder - Senior Manager (email@example.com)
1 Typically, the GP charges management fees during the investment period (the first years of the fund) as a percentage of the money committed. Afterwards, the GP charges fees as a proportion of the money used to buy the portfolio companies that the fund has not yet sold.