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Industry Voices

Commentary: Limited partners need to be aware of GP-led deal pitfalls

"GP-led deals" is a term coined to group together a number of existing techniques that have been used by general partners for many years to engineer secondary market transactions in their favor.

There are two main types of GP-led deals: tender offers and fund restructurings.

Tender offers entail a buyer putting forward an offer to all investors in a fund to purchase their stakes. Such transactions are almost always "stapled" transactions, meaning the buyer will reward the general partner with new primary commitments to a separate fund, in direct proportion to the uptake of its tender offer. Quite simply, the more investors who sell their stakes in the old fund, the more money the GP is able to raise for its new fund. Fund restructurings involve a more fundamental change in the older vehicle. Essentially reopening these funds, the objective is to raise new primary commitments which then may be used to make new investments or inject fresh capital into older assets.

Importantly, in both types of transaction, there is almost always some element whereby the GP benefits, either by raising fresh primary capital or having their economics reset.

A key concern is that GP-led deals give managers a second bite of the cherry. This has potentially serious implications for the way funds are managed. Managers are free to take risks and if they pay off then they get the upside, but if they don't pay off they can nevertheless "restructure" or use a stapling process to raise another vehicle. This possibly gives managers an incentive to take far bigger risks for their investments.

Thus, there is a balance that limited partners must consider between solving near-term fund-specific problems today and creating a precedent that leads to more of these transactions in the future.

The incentive to take advantage of LPs

Last year, the Securities and Exchange Commission fined Veronis Suhler Stevenson for its handling of a GP-led deal. The allegation was the GP had knowingly undervalued VS&A Communications Partners III such that stakes in the fund were sold at below true market value. Blackstreet Capital Management LLC also was fined by the SEC under similar allegations. The recent secondaries process for Charterhouse Capital Partners IX — where a buyer emerged that revealed the true economic value of Comexposium, the fund's main underlying asset. This resulted in the GP-led process being derailed and Comexposium being sold separately.

The problem that limited partners have in these transactions is their utter reliance on the honesty and integrity of the GP. The general partner is relied upon to disclose and deal with all alternatives to their own GP-led process, even where that is not necessarily in their economic interests.

Crucially, GPs set the net asset value of the fund. There is very wide scope and discretion for GPs in determining the valuation. They have the potential means to significantly influence LP investment decision-making by altering (perhaps to their advantage) the basic valuation of the assets in question.

Setting the NAV lower than the true market value likely would lead to an increase in the optical secondary price a buyer was paying. This, in turn, would encourage further sellers. It is a well-accepted feature of the secondaries market that many LPs simply do not sell at below an optical level, often par value (100% of NAV). If the GP were presented with a situation where the secondary price would likely be 90% of NAV, they could simply reduce the NAV, creating the impression the buyer was paying par value. Many of the SEC fines issued to date against GPs have been exactly in relation to the undervaluing of fund interests in GP-led processes.

A lack of impartiality

Investors might consider the following question: Is the intermediary motivated to act in the best interests of the LP or the best interests of the GP? Once this point is appreciated, it can be seen that the intermediaries promoting GP-led deals are neither impartial nor do they have an incentive in any legal or commercial sense to act in the best interests of the investors. In fact, quite the opposite. Fees paid to these groups are ultimately extracted from the value of limited partners' stakes. We suggest this fundamental point ought to be a non-starter for any LP considering a GP-led offering.

In our view, LPs ought to receive the benefit of any placement/intermediary fee in a stapled transaction, not pay it.

LPs ought to be compensated because the GP would not be able to raise fresh primary capital without stapling the sales of existing LP interests.

The pool of limited partners in any fund is a valuable resource. If the GP is able to tap into and extract from that resource a commercial benefit, it is odd that LPs have to pay for that, whether directly or indirectly. Rather, LPs (particular those that actually participated in the process) should receive a fee for being used in that way.

Let's say secondaries in Scandinavian Fund VI were being stapled to help raise a new Asian fund for the GP. If Pension Fund A sells a €100 million position in this fund that would potentially allow the GP to raise €100 million for the Asian fund. The argument would be: Given that the GP would not have been able to raise this money but for Pension Fund A, that ought to create an obligation upon the GP to compensate Pension Fund A for that commercial benefit.

Whichever way this issue is considered, it is inescapable that the GP is using existing LPs to gain a commercial advantage and it is odd that this does not attract a reciprocal fee.

Kishore Kansal is managing partner at PEFOX LLP, London. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.