SEC scrutinizing stapled transactions

General partner-driven stapled transactions, a small but growing corner of the private equity secondary market, are drawing the attention of the Securities and Exchange Commission because of potential conflicts of interest and lack of transparency for limited partners.

The transactions under scrutiny involve the general partner initiating the sale of any remaining portfolio companies from an older private equity fund to a new fund. These deals often require approval from only the advisory committee of the existing fund.

These general partner-led transactions are the latest iteration in the private equity secondaries market. They have become a tool for general partners to wind down old funds while seeding new ones with existing limited partner capital or assets.

Industry insiders say they could lead to breaches of the private equity managers' fiduciary duties to put investors' interests ahead of the managers' and to make certain disclosures to the limited partners that are selling their interests. The concern is that the pricing of the secondary transaction could be affected by the potential relative unattractiveness of the new fund.

“Stapled transactions are often used in situations where a GP may be having a hard time raising a new fund, and by combining a sale of remaining assets in a current fund, with a requirement of the buyer to commit to a staple, the GP can simultaneously provide liquidity for investors and secure an anchor investor for its next fund, regardless of how the prior fund performed prior to the sale,” said Mary Hornby, managing director and general counsel at New York-based private equity funds-of-funds firm Abbott Capital Management LLC.

In separate speeches last month, two high-ranking SEC officials said the agency is concerned about these transactions and agency officials expect that stapled private equity secondary market transactions will be an area of focus for its office of compliance inspections and examinations.

Most of the time, private equity managers seek subscription agreements with limited partners in the existing fund, giving them a choice of whether to cash out of the fund or continue to invest with the manager in a new fund.

In the first iteration of stapled transactions, deals were initiated by a limited partner seeking to sell its share to another LP. As a condition of the GP's approval, which is often required, the GP requires the new LP to commit to another of the general partner' funds, or to a future fund.

Under a GP-led stapled transaction, the GP initiates the sale, and the portfolio companies in the old fund are transferred to a new fund, which can be formed under different terms, including a new hurdle — the return a manager has to earn before taking its share of the profits. These asset-sale transactions can occur with the approval of only the advisory committee, which can leave the rest of the limited partners in the dark until the deal is done, Ms. Hornby explained.

Stapling is a way to restructure a private equity fund, and can prevent a fund from turning into a zombie, which exists to generate management fees with little or no hope of turning a profit, said Charles Van Horne, managing director of Abbott Capital Management.

General partner-driven deals have become the norm for stapled deals, said Tom Bratkovich, managing partner in the San Francisco office of secondary market broker Hycroft LLC.

Currently, stapled secondaries are still a small portion, around 10%, of the private equity secondary market, industry experts say. In 2014, secondary deal volume was an estimated $42 billion.

“We estimate that stapled secondary volume has increased in recent years as private equity firms have sought solutions for "end of life' funds (typically, 9 years old or older) and at the same time, raise capital for new funds,” said Laurence G. Allen, CEO of New York-based secondary market broker NYPPEX.

These deals are growing and expected to continue to become more common, especially if there is an economic downturn, because general partners are more likely to have portfolio companies they can't exit and more likely to have a difficult time raising a new fund in a bad economy.

And there are multiple potential conflict-of-interest issues, Ms. Hornby said. As a funds-of-funds manager, Abbott Capital has been involved on the limited partner side of stapled transactions.

“Often the conflict is as a result of the value given to the assets to be sold,” Ms. Hornby said.

“If a staple commitment is a requirement of the sale, the buyer may be providing a value to the seller that takes into account the risk or return expectations associated with its required investment in the subsequent stapled fund,” she explained. “Is the value available to the seller compromised by the GP's stapled requirement?”

Sometimes a potential buyer of a limited partnership interest will balk at the general partner's “stapling” it to the new fund.

The New Mexico State Investment Council, Santa Fe, considered buying a limited partnership interest in a venture capital fund in 2014 for its in-state private equity investment program.

One of the limited partners needed to sell its stake in the venture capital fund, and the general partner wanted to bundle the secondary deal with a commitment to their next fund, said Charles Wollmann, director, communications and legislative affairs for the council, which oversees $20.9 billion in assets.

“As we couldn't get comfortable enough with the Fund I track record to make a Fund II commitment, we walked from the deal, despite a pretty attractive valuation on the position,” Mr. Wollmann said, who would not identify the selling LP or the manager.

This new breed of stapled secondary transactions is much more complex than the older versions, which were strictly limited partner to limited partner, Mr. Bratkovich said. This makes the amount and quality of information that investors receive very important. He added the industry standard is moving toward greater transparency to ensure a fair price for the secondary transaction.

SEC officials are taking notice.

Igor Rozenblit, co-chairman of the private fund unit within the SEC's office of compliance inspections and examinations, in a recent speech said an area of interest for the regulator is the amount of information being provided to limited partners involved in stapled secondary transactions, “particularly if there is a decline in the economy,” Mr. Rozenblit said at the International Finance Corporation's Global Private Equity Conference in association with the Emerging Markets Private Equity Association last month in Washington.

Marc Wyatt, acting director of the SEC's office of compliance inspections and examinations, hinted of his concern about stapled secondary transactions in a May speech at the Private Equity International Compliance Forum in New York.

“The private equity industry has experienced strong growth in the past few years, but we all know that private equity markets are cyclical,” Mr. Wyatt said. “Current levels of dry powder and transaction multiples make me worry that, at some point, the markets will start to recede and that the outgoing tide may reveal disturbing practices which will need to be addressed. Issues such as zombie advisers and fund restructurings may again come to the fore as we move through the business cycle.”

But people in the industry have worked hard over the last few years “to create norms to minimize, if not eliminate, conflicts of interest between the LP, the GP and the buyer,” Hycroft's Mr. Bratkovich said. These new industry standards aim to give limited partners a choice and “maximum fair value” for the sellers.

Consultants say the amount of transparency in even plain-vanilla secondary transactions leaves much to be desired.

“There needs to be a better balance between the LPs' desire for liquidity and the GPs' interests to survive or exit gracefully,” said Thomas K. Lynch, senior managing director in the New York office of alternative investment consulting firm Cliffwater LLC. “The asymmetry of information is caused by the (GP-LP conflict of interests) ... No one LP, and for that matter an advisory board, wants the responsibility of determining fair value of a troubled partnership.”

NYPPEX's Mr. Allen said: “In general, we believe, general partners are careful not to provide information to secondary buyers that has not been provided to current limited partners.”