This article:

1. Explains briefly “What is a secondary?” a sale of interests in one or more private funds by an existing fund investor (for example a pension fund);
2. Reports on the current market for secondary transactions by reference to statistics for 2023 referenced from a survey of investors and identifies that there is a good opportunity for pension fund investors to achieve some liquidity from their private fund investments by selling or rebalancing their private fund portfolios in 2024; and
3. Explains the key stages of the transaction process required to effect a sale of private fund interests in a secondaries transaction.

What is a secondary?

A secondary transaction is the transfer of interests in private funds from an investor in the fund to a third party buyer.  Secondaries can involve the sale of a single interest in a fund, or a portfolio of interests held across several different funds.

Secondary market trends

The secondaries market for the sale of fund interests provides investors in private funds with the means to achieve liquidity, before the expiry of a fund’s life.  The size of the secondaries market has grown hugely over recent years and now provides pension funds with the opportunity to obtain liquidity for what is traditionally seen as an illiquid asset class.

Transaction volume in the secondaries market in 2023 reached $114 billion, up from $103 billion in 2022 despite a “more challenging fundraising environment overall” according to data from investment bank Evercore’s FY 2023 Secondary Market Survey Results, published in Secondaries Investor. The period was the second biggest year on record for secondaries transaction volume according to Evercore’s report.

Market expectations are for increased activity in 2024. Predictions are that demand for secondaries sales will continue to be driven by investor appetite for liquidity, resulting from both the shortfall of returns from exits in the subdued M&A market and from the requirements of general portfolio management. A narrowing of the pricing gap between buyers and sellers of fund interests is cited as a key reason why there should be sufficient buyers willing to meet the demand from secondaries market sellers.

The October 2022 LDI crisis, and the significant rise in gilt-yields over the last 2 years have seen the assets (and liabilities) of many pension funds drop significantly.  This has meant many schemes now find themselves overweight in private equity, and need to rebalance their portfolio.  Additionally, with lower leverage in LDI funds, and hence a need to post more collateral to maintain interest rate and inflation hedges, pension fund trustees may need to consider selling their private equity interests to generate liquidity and to manage their cash flow.

This article covers the key stages that the trustees of pension funds will need to consider when they undertake an auction sale of fund interests, so they are in the best position to take advantage of the market re-opening and pricing improving.  Trustees should also consult the sponsoring employer (this is good practice in any event, but will be necessary if the trustees need to amend their statement of investment principles to implement a sale).   

Step 1: Appointment of intermediary

It is customary to appoint a specialist intermediary who will help with the selection of the fund interests being sold, the pricing of the interests, the auction process and, after one or more preferred bidders are selected, the sale process itself. They will act as a broker between the trustees and the buyer. They will also help facilitate the interaction with the GPs or managers of funds in which the seller has fund interests it wishes to sell. The intermediary will typically seek to be remunerated based off  a percentage of the value achieved in the same.

Step 2: Selection and pricing of fund interests

It is important to define the portfolio of fund interests being sold, and for the trustees to set internally a floor price to be established for each fund interest, below which the trustees will not sell. What may in the past have made a portfolio more attractive to a range of buyers was its diversity - particularly in its vintage, location and sector. However, sales processes since the pandemic have often been more concentrated, with more recent fund vintages being easier to sell than older funds with little or no undrawn commitments (i.e. “tail end funds”). Bidders in auctions have also tended to focus their efforts more on funds that they already know rather than expend resources on undertaking due diligence on funds that they don’t know. The underlying economic conditions affecting portfolio companies in certain sectors may also have had an effect on the fund interests in certain sectors (e.g. at some points in the recent economic cycle it may have been easier to obtain best value for interests in infra or debt funds than in PE funds that have focused on consumer and retail). A seller may find that they are advised to sell their portfolio of fund interests to a number of different buyers to achieve the best overall pricing outcome.

Pricing on secondaries runs off the most recently available Net Asset Value ("NAV") reported by the GP of the relevant fund (such reports being issued by the GP quarterly) and the pricing for a fund interest in a fund could be at NAV, a discount to NAV, or a premium to NAV - with all cash or with a deferred element.

Step 3: Creation of data room and vendor due diligence

Our experience is that it is becoming more important to undertake some level of vendor due diligence so as to minimise the risk of any fund interests falling out of the transaction or any disruption to the sale process, and to ensure that any pre-transfer processes are fully understood and complied with. At an early stage in the process, it would be prudent to:

• collate the key documents for the fund interests being sold (e.g. limited partnership agreements (“LPAs”), any side letters, subscription documents, and (if applicable) any alternative investment vehicle  documents);
• populate an electronic data room with the key documents;
• instruct lawyers to prepare a limited scope sell-side due diligence review of the key documents for the fund interests being sold, in order to identify any material issues that may impact on the sale (e.g. LPA transfer restrictions, confidentiality requirements, and any limited partner (“LP”) giveback obligations);
• seek the consent of each relevant GP to key materials being made available to bidders;
• prepare a non-disclosure agreement (“NDA”) that bidders will be asked to sign (and which is ideally in a form approved by the GP); and
• undertake an initial review for tax issues that the seller and buyer may encounter, in particular, whether there are any fund interests which may require the buyer to withhold amounts from the purchase price and whether such withholding can be mitigated (for example as a result of U.S. tax issues such ECI and FIRPTA  for non-U.S. sellers where certificates from the seller/GP may be required by the buyer).

Unless the GP is involved in the transaction (e.g. tender offer intermediated by the GP),  the buyer of the interests will not be able to amend the LPA terms. However, the buyer may negotiate a side letter with the GP to deal with some types of issues arising from the LPA as well as any special requirements for the buyer. The seller may wish to control any side letter process taking place prior to closing of the transaction, to prevent the buyer’s own requirements creating a delay to closing.

Step 4: Launching of auction process

This phase of the process is led by the intermediary. The data room will be opened up to potential buyers (who have each signed an NDA), who will undertake due diligence on the performance of the underlying investments in the fund and the key terms of the fund documents. The trustees may wish to consider if they wish to keep the pension fund's identity confidential at this stage of the process.

The seller and intermediary will decide how they wish to balance a swift execution, maximising of price and minimising of legacy liabilities. This could involve dealing with one or more preferred buyers, who would be granted a limited exclusivity period. Alternatively, it could involve dealing with a large group of bidders, with none granted exclusivity or preferred bidder status until final form documents are agreed. The process could also involve multiple bidders for different parts of the overall portfolio, some of whom will be relying on leverage.

Step 5: Negotiation and signing of the Purchase and Sale Agreement (“PSA”)

The PSA is the main transaction document pursuant to which the trustees of the pension fund (as the seller) agree to sell the fund interests to the buyer, and will almost always require a split exchange and completion to allow time to obtain consent/s from the GP/s and to implement any other actions required at fund level (e.g. a right of first refusal process) or otherwise to effect the completion (see Step 6)..

The key terms of the PSA to be considered are:

• limitations on the trustees' liability under the PSA
• the purchase price mechanic, under which the purchase price for each fund interest being sold is adjusted for “calls” and “distributions”. This means that (i) the amount of any distributions received by the trustees in respect of a fund interest in the period from the date that the NAV of the fund interest was determined up to closing under the PSA is deducted from the purchase price and (ii) the amount of any drawdowns paid by the trustees in respect of the fund interest for the same period is added to the purchase price;
• the parameters of "excluded obligations" (i.e. obligations that will remain with the trustees after the sale, such as certain tax liabilities or any LP give back obligations);
• the conditions precedent to completion;
• protections during the period between exchange and completion;
• warranties and indemnities
• the split of GP costs and any transfer taxes; and
• risk allocation and practicalities in respect of any withholding tax.

Trustees of pension funds will want to manage their exposure to legacy liabilities after the sale of the fund interests has completed, through the time periods under which the buyer can make a claim under the PSA and through limitations on the quantum of claims that the buyer can make . These and other limitations will be heavily negotiated in the sale process. Trustees need to determine at the outset of the sale process what legacy liabilities they are able to retain commercially and legally.  If the trustees are required to provide limited indemnities to the buyer under the PSA, they will need to check their trust deed and rules to determine whether sponsoring employer consent is required to the granting of such indemnities.

On a portfolio sale, the PSA will need to provide a mechanism for a scenario where not all of the fund interests can be transferred (e.g. because a fund interest is taken up during a right of first refusal process, or where a GP does not consent to the transfer). Some buyers may want all of the fund interests transferred or none at all (i.e. one closing) which will be impractical on larger portfolio sales. More often, we see a construct where either (a) a certain number of fund interests, expressed as a percentage of the base purchase price, need to transfer at first closing, or (b) certain specified, key fund interests need to be transferred at first closing.

Some thought will be required in relation to the signing process for the PSA and any assignment and assumption agreement (or transfer agreement), to ensure that the risk of UK stamp duty applying to the sale of the fund interests is minimised.  

Step 6: Completing the transfer process

The PSA does not transfer the fund interest. Completing the transfer process largely involves negotiating and settling the assignment and assumption agreement (or transfer agreement) for each fund interest that is being transferred. In nearly all cases, the form of agreement will be provided by the GP for the seller and the buyer to jointly mark-up prior to negotiation of any material points of difference.

An assignment and assumption agreement will commonly also contain the representations usually found in a fund subscription agreement. If not, the buyer may need to enter into a separate subscription agreement .

At the conclusion of this process, the transfer by the seller of title to the relevant fund interest(s) needs to be carefully coordinated with receipt of payment from the buyer. Time zone issues can often make this process more complicated and fraught than it ought to be.

Hogan Lovells Secondaries team

The above is a starting point for trustees of any pension fund considering a secondary sales process. Each process will have its own dynamics and drivers. If you are considering a sale process of fund interests and have any questions relating to the issues raised in this article please contact one of the Hogan Lovells Secondaries team.

Authored by Edward Brown, Ed Harris and Leanne Moezi.