Anatomy Of A Secondary Transaction

Over the past 10 years, private equity assets have proliferated throughout the institutional investment community. Many owners of private equity limited partnership interests hold their investments from initial commitment to fund termination. Others need or desire liquidity prior to the dissolution of the funds. Since 1989, Landmark Partners Inc. has been a leading participant in an increasingly robust secondary market for private equity and real estate limited partnership interests. Due to the structure and illiquidity of private equity limited partnership investments, there is an involved process associated with their sale and transfer. This process begins with the decision to sell the assets and ends with a closed transaction in which the buyer takes title to the limited partnership interests and becomes a substitute limited partner.

The seller must decide which type of sale process is most likely to meet its goals. Transactions can be negotiated directly between the seller and one buyer. These typically take the least time to complete, with a minimum of distractions and hurdles. Transactions can also be auctioned to a limited number of buyers or to a broad spectrum of buyers. In both negotiated and auctioned deals, the seller can either manage the process itself or engage a third party to do so. Whether the seller decides on a negotiated or competitive process, it must select buyers with which it wants to work. Buyers should be selected based on their track record and reputation, experience, ability to fund the transaction, ability to complete complex transfers, and ability to maintain confidentiality.

Buyers require access to fundamental information regarding the assets, including partnership operating agreements, quarterly and annual fund business reports and financial statements, and the seller’s capital account statements. Transactions are typically priced from the date of the most recent financial statements. Therefore, buyers require notice of all fund cash flows since this pricing date. Buyers also want access to the underlying general partners to conduct partnership and company level due diligence on the assets.

Due diligence begins with a legal review of the assets, focusing on transfer mechanics, ERISA and Company Act issues, and pending or current litigation at the partnership and company level. The analysis of a secondary transaction includes aspects of both fund manager evaluation and asset evaluation. Manager evaluation centers on ascertaining the experience level, skill, and success of the general partners managing the funds. Key considerations include the background and history of the firm and its principals, the firm’s investment strategy, and its track record. Asset evaluation focuses on current and projected valuation analysis. The buyer assesses the appropriateness of the current investment values and does so in the context of financial performance, company development, balance sheet health, and financing requirements. Comparable company analysis is an important analytical tool in the process. An equally important component is a qualitative review developed from detailed due diligence calls or visits with the general partners. From this work, the buyer develops a cash flow forecast, by fund and by company. This forecast is used in sophisticated return models to generate a purchase price for the assets.

The buyer will submit a purchase proposal to the seller, most often in the form of a non-binding letter of intent. The letter of intent includes basic terms, such as purchase price, pricing date, non-solicitation, and a timeline for closing the deal. In the case of a negotiated transaction, there may be some compromise on pricing and terms. In a competitive process, the highest purchase price is selected, as price is the primary consideration for sellers utilizing an auction.

Upon acceptance of the letter of intent, the parties move directly into the negotiation of the purchase and sale agreement. These discussions usually focus on the same issues: representations and warranties, covenants, and indemnification. In general, a buyer will not proceed with a transaction unless the seller represents that it is transferring good title and unencumbered assets. Buyers also prefer to be indemnified against liabilities that arise from actions taken prior to the pricing date.

Closing occurs when the buyer receives transfer consent from the underlying general partners and the buyer pays the Seller. Closes can occur with the simultaneous execution of all documents and payment or on a rolling basis where assets are transferred and paid for in baskets. In either case, the seller is released from all future obligations and the Buyer becomes the substitute limited partner.

Secondary sales have become an accepted and important tool for private equity portfolio managers. Although this outline generalizes an ideal transaction, working with a highly experienced and reputable buyer can greatly facilitate the process and mitigate deviations from the above framework.