Over the past year secondary buyout transactions have become the increasingly common move of primary private equity fund managers seeking to exit their portfolio company investments in Europe and the United States. Secondary buyouts, also referred to colloquially as “pass the parcel” deals, occur when one private equity firm sells its stake in a portfolio company to a second private equity firm. ((Secondary buyouts are not to be confused with the similar sounding “secondaries” or “secondary market purchases” which involve the sale or acquisition of entire portfolios of assets, or a portion thereof. Such transactions are common when a limited partner wishes to exit a fund investment and thus sells its stake to another limited partner. In secondaries the new limited partner assumes not only the rights or stake of the underlying position, but often also assumes any remaining capital contribution requirements.))
While there are various underlying causes of these transactions – such as regulatory reform mandating divestment, as is the case in the United States with Dodd-Frank, or exit market stagnation, as is the case in Europe – they share a common feature of raising concern that the incentives of portfolio managers may diverge from those of portfolio investors. In these transactions it may well be the case that investors take the ultimate hit of a failed investment while the general partner fund managers escape relatively unscathed. These divergent interests are not per se conflicts of interests, but they will become of increasing relevance to transactional players as firms engage in more secondary transactions. Accordingly, prospective limited partner investors would be wise to consider these possible outcomes.
As a fund’s expiration date approaches, its managers are required to free-up capital so as to prepare to distribute returns to investors. But liquidating investments may not be in the economic best interests of fund managers, who are also awarded management fees simply by having control of the assets. In a capital sparse economy or in a market in which investment supply outpaces demand, fund managers may seek to protect their own interest at the expense, or potential expense, of their limited partner investors, to whom they owe certain fiduciary duties. These concerns are exacerbated when the managers would receive a miniscule amount or even no part of the distribution proceeds. Ironically, such conflict of interest scenarios are most likely to occur when limited partners have advocated for a preferred return that entitles them to distributions, usually in the realm of 6 to 8 percent, before general partners are entitled to carried interest distributions. Because a preferred return gives limited partners the first bite of the apple when it is time to divide up fund assets, in a world where final distributions are low – such as in a poorly performing exit market – general partners are incentivized to take what they can while they are still able to do so. The main card up the general partners’ sleeves is to churn the portfolio, pulling the 2 percent fee off the top for the remainder of the fund life.
One of the most useful roles of secondary purchasers is in resurrecting the holdings of so called “zombie funds,” described above, which are older funds that are run by managers who are effectively “running out the clock” until the fund’s life officially expires. ((See Jeff Hammer & Paul Sanabria, Curing Private Equity ‘Zombies’, The Deal Pipeline (Oct. 23, 2013), http://www.thedeal.com/content/private-equity/curing-private-equity-zombies.php.)) In such situations, the secondary buyer takes over control of the portfolio of investments, allows the investments to continue past the expiration date of the initial fund. Unfortunately, often times, secondary buyouts are not the most lucrative exits for private equity funds, which instead prefer pursuing avenues such as IPOs and strategic acquisitions by trade buyers for their portfolio companies. ((See Jason Karaian, Pass the Parcel, Quartz (Nov. 9, 2013), http://qz.com/145416/broken-companies-may-finally-escape-private-equitys-game-of-hot-potato/.)) As a result, these deals sometimes carry with them a connotation of desperation on the part of the primary fund managers.
Secondary buyouts benefit portfolio company officers, new fund managers and new fund limited partners, but often at the expense of the prior fund managers and the prior fund limited partners. Current fund managers can minimize their losses by holding onto portfolio company investments for as long as possible by conducting the secondary sale, thus maximizing management fees. Fund investors have no such option. In a down market, they are forced to shoulder the effect of a low sale price and/or pay high management fees as a result of zombie fund churning.
Confounding the paradox confronting initial fund limited partners is the apparent lack of a way to share losses when a fund underperforms. For example, suppose that one knew an investment would rapidly increase in value over the next 10 years. In this case investors may simply wish to continue to maintain their investment. But, continued investment is not possible for three reasons. First, when a new general partner manages the investment, that general partner brings its own limited partner investors (without which the secondary buyer would not have the capital to purchase the investment in the first place). Suppose instead that there was no secondary transaction. The second impediment would be general partners, who have an incentive to close down a fund at a given point in time so that they can redirect full efforts to fundraising and managing a new fund. Third, other limited partners themselves expect the fund to close down at a specified point in time so that they could access the cash that was contributed several years ago.
Other mechanisms to align incentives are also unlikely to be successful. While most contractual arrangements are designed to align incentives for gains, they lack such alignment on loss sharing. If a fund is wildly successful, general partners will take 20% of the returns after the limited partner investors were paid off, leading to a situation where everyone is happy. If the fund is modestly successful or unsuccessful, preferred returns ensure that limited partners get paid first, and maybe are the only ones who have capital returned, while general partners leave without any of the proceeds from the fund outside of their management fees. But a preferred return does not play a significant role where a fund is very unsuccessful. Instead, limited partners get back what they can while fund managers need not provide any extra cash. In fact, fund managers still make profit in a loss situation because the fees resulting from assets under management are awarded no matter what result occurs. One could imagine a situation where a clawback required fund managers to affirmatively replenish limited partners for a portion of the losses, but the money will likely be unrecoverable (either allocated general operating expenses or spent on assets that have since depreciated in value such as a boat). Alternatively one could require fund managers to invest an amount that is double what the projected assets under management fees would be over the life of the fund. This high barrier to entry would likely deter many fund managers from entering the field. Moreover, such a term would be nearly impossible to negotiate.
To gain a better sense of some of this problem, consider the rise of secondary buyouts in both Europe and the United States.
The European Cause
The IPO and M&A markets have faced headwinds on account of the region’s economic turmoil. ((See id.)) Consequently, secondary buyout transactions have increased rapidly since the year 2008. ((Surge in Secondary Buyouts Set to Continue, Preqin (Nov. 17, 2011), https://www.preqin.com/docs/press/Private_Equity_Nov11.pdf.)) The global head of private equity at Blackstone, Joseph Baratta, recently commented on the high levels of secondary buyouts, noting that their prolific use is “not a sign of health.” ((Becky Pritchard, Blackstone’s Baratta Hits Out at Secondary Buyouts, Financial News (23 Oct. 2013), http://www.efinancialnews.com/story/2013-10-23/baratta-blackstone-private-equity-secondary-buyouts?ea9c8a2de0ee111045601ab04d673622.)) Baratta added that over 75% of deals above $500 million in enterprise value involved one sponsor selling to another, a problem when corporate M&A is the “lifeblood” of the private equity business. ((See id.)) In the words of Baratta, the problem is that “there is a lot of capital, there is no corporate M&A of any substance, [and] there is very little primary private equity deal flow.” ((Id.))
Firms can only “pass the parcel” for so long before investor capital and their willingness to invest runs out. So long as few corporate M&A deals and public offering exits for the existing holdings occur, neither primary nor secondary funds will be able to free up capital to reinvest. Intuitively, because of transaction costs and maintenance (management fees) the proverbial pie risks being shrunk with every transaction and every passing quarter. Accordingly, there is a limit of both time investments are sustained and resources that can be committed without results.
The United States Cause
Unlike in Europe where there is not enough primary activity and corporate M&A to sustain a well-functioning private equity market, in the United States the problem resides in the fact that certain participants in the private equity space are being forced, via a new regulatory regime, to divest certain investments. The Volcker rule, among other things, prohibits proprietary trading by banking entities and restricts those entities from sponsoring, investing in, or having certain relationships with hedge funds and private equity funds. ((The Volcker Rule Proposal: Regulators Propose Restrictions on “Covered Funds”, PWC (Dec. 2011) http://www.pwc.com/us/en/financial-services/regulatory-services/publications/closer-look-volcker-covered-funds.jhtml.)) Notably, a bank with federally insured deposits may not serve as either a general partner fund sponsor or a limited partner investor beyond a specified limit of 3% of the bank’s tier 1 capital. This legislative mandate has caused major banks to seek the secondary buyouts as a way to quickly liquidate prohibited positions.
During the divestiture, banks have certain goals – to gain compliance with the federal regulations and also to profit on the investment activities they have undertaken. Assuming the primary motivation is to comply with federal regulations, banks may exit transactions early, potentially at a loss. The problem of underselling becomes exacerbated when the market is flooded with sellers because this enables buyers to demand discounts, which they do. ((Karlee Weinmann, Secondary Buyout Market Heats Up As Volcker Effect Looms, Law 360(Oct. 25, 2013), http://www.law360.com/articles/482465/secondary-buyout-market-heats-up-as-volcker-effect-looms.)) Nevertheless, investors concerned about sub-optimal secondary buyouts have been given a temporary solution: the illiquid fund exception permits banks to use a five-year exemption with a possible additional five year extension if they cannot divest the assets under certain conditions. ((Dan Primack, Goldman Sachs Still Earns Its Money in Soon-to-be Banned Ways, CNN Money (Jan. 22, 2013), http://finance.fortune.cnn.com/2013/01/22/goldman-sachs-volcker-rule/.)) As such the Volcker rule has provided a way to mitigate the deleterious effects of misaligned incentives that might otherwise occur with premature sales.
In conclusion, limited partners bear most of the downside risk to poor investments or poor market conditions, as is illustrated by the European market. Investors internalize losses while simultaneously paying fund managers who may engage in churning. Because the American problem was created legislatively, a temporary legislative safe harbor – the illiquid fund exception – can mitigate the negative consequences of requiring widespread divestment. Nevertheless, there are no easy contractual solutions to the zombie fund problem. As a result, regardless of where one invests, perhaps the age old maxim of caveat emptor retains salience in the modern day of private investment funding.