United States: Secondary Market Advisory Newsletter - May 2018

Welcome to the first edition of the Duff & Phelps Secondary Market Advisory Newsletter. Topics include:

  • Discussion of the impact of U.S. tax reform on the secondary market by Richard Olson, Managing Director, Secondary Market Advisory
  • Mathais Schumacher (Managing Director, Valuation Advisory) offers best practices for navigating fund restructurings
  • A calendar of upcoming Duff & Phelps events
  • Secondary market demand interest summary


In This World, Nothing Can Be Said to Be Certain...

The potential impact of new U.S. tax regulation on secondary market transactions

By: Richard Olson (Managing Director, Duff & Phelps Secondary Market Advisory), with contributions from Duff & Phelps Transaction Advisory Services.

It's tax season for many of us (the United Kingdom, Ireland and Australia all get to wait until October). As we file extensions and fight the creeping urge to procrastinate, spare a thought for the mighty tax accountants, toiling under the burden of the new U.S. tax overhaul. Much ink has been spilled over the impact of reduced corporate taxes in the U.S., or the relatively minor changes to carried interest tax breaks, but there are potential secondary market impacts as well.

A quick review: non-U.S. investors into both non-U.S. and domestic U.S. partnerships that then invest into pass-through businesses operating from permanent U.S. locations face a tax on the income and gains from those businesses (so-called "effectively connected income" or "ECI"). The U.S. Internal Revenue Service argued that this rule also applied to gains from the sales of interests in partnerships that conducted such businesses;1 a view that went unchallenged until a July 2017 U.S. tax court decision removed the IRS's ability to tax such sales.2

However, at the end of 2017, Congress3 effectively reversed that court ruling on taxes applying to gains from the sale of U.S. partnership interests. Without a corporate blocker, non-U.S. sellers of U.S. partnership interests are once again facing taxes on gains. The U.S. Joint Committee on Taxation estimates that the new tax will generate an additional $3.8 billion in cumulative revenue over the next ten years.4 In addition, buyers (both non-U.S. and U.S.) are now obligated to withhold 10% of any gross sale proceeds to sellers who fail to provide a non-foreign affidavit – an obligation that could far exceed the actual tax that would be imposed with respect to the sale. This brings new meaning to the phrase "caveat emptor."

Before your eyes glaze over any further, or panic seizes your chest as you choke on your morning croissant, know that your friendly tax advisor stands ready to help.5 We'll leave you with a quote from Mark Twain — "The only difference between a tax man and a taxidermist is that the taxidermist leaves the skin."


Q&A with Mathias Schumacher, Managing Director

For our inaugural Q&A, we are pleased to welcome Mathias Schumacher from our London Valuation Advisory Services. Mathias is the Valuation leader for the U.K. and co-city leader for London, and is responsible for Portfolio Valuation services across Europe – those services specifically tailored to funds. Mathias has over 20 years of international valuation experience advising private equity firms, hedge funds, BDCs, sovereign wealth and infrastructure funds. Mathias holds a B.B.A. in finance from the Verwaltungs und Wirtschaftsakademie in Germany and a degree from the Paris-Sorbonne University. Mathias also serves as an Associate Fellow of Said Business School at Oxford University, where he is a lecturer on the topic of Valuation.

Q: You recently led a firm engagement to provide a fairness opinion in a high-profile secondary market transaction. Can you tell us a little bit about that?

A: The buyout fund came towards its end-of-life and still had over $1 billion of illiquid assets spread across multiple investments. The sponsor felt that holding the assets beyond the life of the fund would yield significant upside to the LPs. It therefore offered the LPs the opportunity to transfer the assets into a continuation vehicle or sell the investments to a new secondary investor in this continuation vehicle. This provided the LPs the choice between immediate liquidity or the opportunity to remain in the fund with an extended life. The Limited Partner Advisory Committee asked the sponsor to obtain a fairness opinion to ascertain whether the consideration received in the proposed transaction was fair from a financial point of view.

Over the course of three weeks we assessed the fair value of each underlying investment of the fund, determined a range of value for all investments and on that basis determined the fairness of the proposed transaction.

Q: Are fairness opinions common for secondary market transactions? Why or why not?

A: Across the private equity industry I believe it is now common practice to obtain a fairness opinion that the Board of Directors can rely on when a related party transaction is contemplated. Often, this may only include a single investment that is transferred between funds, but it may also encompass an entire portfolio that is transferred into a continuation vehicle.

As sponsors represent both sides of transactions, likely acting for different groups of LPs, they have to ensure that the transaction is fair to both sides so that they meet their fiduciary duties. We may be asked to provide a fairness opinion stating that the transaction is fair to the buyer and the seller (two-sided opinion), or we can provide an opinion to only one side, typically the selling entity.

Q: What are some of the pitfalls in providing a fairness opinion in these types of deals?

A: For multiple reasons, I think most sponsors try to avoid situations in which they benefit most from entering into a related party transaction. It is always viewed as a sign of weakness when it is best to hold on to the investment after a holding period of, say, five to seven years and transfer the investment to a new fund. There are, however, unique situations where the expected future return justifies the transaction. The sponsor is ultimately very familiar with the investment and can judge better than any outsider the future prospects of a company.

It is now critical to share the upside and associated risk between the selling and buying parties. We come in as an independent party and try to assess this very point.

Q: When you're not contemplating sky-high valuations, you are scaling Himalayan peaks – should we worry about spending long periods in low oxygen environments?

A: I will let colleagues and clients judge whether my exposure to low oxygen has had any negative impact on my judgement. I haven't noticed any yet, but I may be biased. What I can say with confidence: it provides a new view on the risk and reward equation.


As in 2017, secondary market pricing remains strong in 2018. In our conversations with secondary market buyers, we noticed an eagerness to put capital to work in high-quality assets paired with a 

reluctance to over-extend in an environment that many consider to be extremely competitive. Many buyers are seeking to differentiate themselves by pursuing interests in specific investment strategies and middle-market managers.

Interested sell-side parties, please click here to request further private equity and hedge fund pricing information:


1. IRS Revenue Ruling 91-32, 1991-1 C.B. 107.

2. See also Grecian Magnesite Mining, Industrial & Shipping Co., SA, v. Commissioner, 149 TC No. 3 (July 13, 2017); The ruling excludes gains from the sale of U.S. real property.

3. United States House of Representatives bill H.R. 1, originally known as the "Tax Cuts and Jobs Act," was signed into law on December 22, 2017.

4. Source: "Estimated Budget Effects Of The Conference Agreement For H.R.1, The 'Tax Cuts And Jobs Act'", Joint Committee on Taxation, 2017, Page 5.

5. Consult your tax advisor (preferably Duff & Phelps) for more details and specifics. Duff & Phelps Transaction Advisory Services contributed to this article. This column should not be construed as advice.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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