In this Ropes & Gray podcast, asset management and tax attorneys Emily Brown, Alex Chauvin, Isabel Dische and Dan Kolb discuss some considerations for institutional investors who are contemplating a secondary sale and some steps they can take to facilitate a portfolio rebalancing. Their discussion covers, among other things, a brief explanation of why an investor may want to pursue a secondary sale, typical deal processes and certain considerations LPs will want to keep in mind, how to reduce deal execution risk and certain key tax considerations.
Transcript:
Isabel Dische: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on topics of interest for asset managers and institutional investors. I'm Isabel Dische, a partner in our asset management group based in New York. Joining me today are my asset management and tax colleagues, Emily Brown, Alex Chauvin and Dan Kolb. Today, we are going to be talking about some considerations for institutional investors who are contemplating a secondary sale and some steps they can take to facilitate a portfolio rebalancing.
We'll start with a brief explanation of why an investor may want to pursue a secondary sale. We'll next discuss typical deal processes and certain considerations LPs will want to keep in mind, as well as how to reduce deal execution risk. Finally, we'll quickly cover certain key tax considerations in these transactions.
Emily, would you like to set the stage and explain why an LP may be considering a secondary sale, particularly now?
Emily Brown: Gladly. A few factors have led LPs to consider secondary sales in recent months. Some sales are driven by broader macro concerns. Perhaps at the top of the list is a question of portfolio allocation: given the divergence between public and private market valuations (the latter tend to lag the former), a number of institutional investors have found themselves over-weighted to private exposures. Depending on the parameters of an investor's investment program, it may be under an obligation to rebalance its portfolio to correct that skewing. Another factor that has driven some of our investor clients to consider secondary sales recently is the divergence between fundraising timelines and exits from prior vintages, which is only exacerbated as fund sizes grow larger. Put another way, some LPs may need to realize current positions to have capital to deploy to new funds.
Setting aside macro factors, LPs also may want to rebalance as part of their normal course reevaluation of their relationships—for example, as part of a program to concentrate their exposures with favored sponsors.
Private fund interests are by their nature illiquid assets, however, so rebalancings are more involved than simply calling a broker and placing a sell order.
Alex Chauvin: That's absolutely the case. A potential seller will need to find a buyer, negotiate a purchase agreement, and then, negotiate the transfer agreements with each of the underlying funds being sold. Each of these steps takes time and, because most funds only process transfers on a quarterly basis (but in some cases only semi-annually), it may be many months, or even longer, between when a seller starts a secondary sale process and when the deal closes.
As a first step, a potential seller will need to decide whether it wants to engage a banker or not. What makes sense will depend on the parameters of the transaction contemplated. For example, if an LP is selling only a single fund interest and the fund in question has a list of approved buyers, a broker may not make sense (presuming the LP's comfortable taking on the work of interfacing with those potential buyers). Conversely, if an LP is looking at a larger sale, a broker can add real value both in terms of managing a more complicated process with numerous buyers and helping navigate an optimal "sale mosaic"—that is, figuring out how to divide up the portfolio across multiple sales in order to maximize the overall pricing. Brokers can also provide a sense of indicative pricing which can help a seller evaluate its options and can help with the sales process itself, which can be fairly time consuming—confidentiality agreements, various confirmations with the GPs, establishing a data room, communications with potential buyers, chasing GPs on transfer agreements, etc.
Isabel Dische: With or without a broker involved, there are a few steps a seller can take to make a sales process go more smoothly. First, in tandem with any preliminary discussions about the potential sale, it behooves sellers to start gathering copies of the core documentation buyers will want to see—LPAs and any amendments, capital account statements, side letters, sub docs, details of any AIVs through which the seller is invested and, as we'll discuss in a bit more detail later, any non-U.S. sellers will want to gather the last three years' K-1s and other tax forms the seller may have received from the underlying funds. Sellers also will want to understand from each GP what they can share with potential buyers so the seller doesn't breach its confidentiality obligations. Two other points that sellers will want to check earlier in the process rather than later are whether there are any rights of first refusal, as the mechanics of a ROFR process can delay closing. They'll also want to check whether the GP will delay transfers for publicly traded partnership (or PTP) reasons. We've seen some GPs impose PTP delays of several years.
In a typical sales process, sellers will solicit bids, sign an LOI with the preferred buyer or buyers and then negotiate the purchase and sale agreement (or PSA). Brokers can be particularly helpful at the bid stage of a deal where a seller's selling a larger portfolio of funds, as they can provide guidance on which funds are comparative "gems" or "dogs," and guidance on how interests may be grouped so as to maximize the overall price. For example, a potential buyer may be willing to pay more for a particular interest if buying only a part of that interest, or requiring buyers to buy a "dog" if they want to purchase a "gem" might make more sense.
Note that for larger portfolios, it is increasingly common for sellers to "mosaic" the sale to maximize the overall pricing—selling different parts of the portfolio to different buyers.
Alex Chauvin: Once the winning buyer (or buyers) has been chosen, a seller will want to decide whether or not to sign a letter of intent with the buyer. While secondary LOIs are fairly short, a seller will want to make sure that the buyer has not included anything problematic. For example, we've seen buyers include a condition that none of the funds being sold is blocked, even when buying from a non-U.S. seller. LOIs also often include exclusivity provisions which limit the seller's ability to engage with other buyers, and even if conceptually acceptable, particularly for mosaic sales, those provisions can introduce issues for a seller if not drafted properly.
Typically, sellers provide the first draft of the PSA. One way a seller can try to take advantage of the competitive bid dynamic is to ask potential buyers to provide PSA comments in connection with their bids, as buyers may be more restrained with their comments when they are trying to "win" a deal.
Typically, parties wait to negotiate transfer agreements until after the PSA is signed, but timing may drive the negotiation of both in tandem as most funds will only permit transfers at quarter-end (or in some cases, only semi-annually).
And as Dan reminds us frequently, one shouldn't forget about tax.
Dan Kolb: That's right. Secondary sales involve a number of tax issues, in particular, for non-U.S. sellers.
As our listeners may recall, due to an unfavorable court ruling in 2017, the U.S. government amended Section 1446 of the Code to clarify that the sale of an interest in a partnership with a U.S. trade or business by a non-U.S. seller was taxable, and to impose withholding requirements on the buyer and the underlying fund with respect to partnership interest transfers. The regulations generally require withholding whenever the seller or underlying fund cannot, or in the case of underlying funds will not, provide appropriate certificates. As an example, while many sellers will be able to provide an exemption certificate based on the representation that their last three K-1s from an underlying fund reflect minimal or no ECI, if the underlying fund has not existed long enough to provide the seller with three K-1's, or the fund has such limited contact with the U.S. that it does not issue K-1s, this exception does not apply.
Because beginning on January 1, 2023 funds will have a withholding obligation on distributions to a buyer if the buyer (who has primary withholding responsibility) does not properly withhold on the seller, buyers want to make sure that sponsors of the funds in which they are buying interests agree with their withholding analysis. We expect that this fund withholding obligation will force funds to increase their involvement in the transfers. It certainly has created a bit of fear in the buyer community as to the extent a sponsor withholds on distributions to a buyer, that withholding would generate a tax credit for the seller, not the buyer. (Note, too, that a partnership can withhold even if the relevant certificates are otherwise in good order, so buyers and sellers will want to make sure underlying funds agree with their analysis.)
Generally, the withholding obligation is 10% of the amount realized on the transfer, but that amount realized includes not only the purchase price, but also the seller's allocable share of fund liabilities. The amount of assumed liabilities is a figure that can change practically daily. The Treasury Department has helpfully clarified that a buyer will not need to withhold more than 100% of the purchase price.
Because of the risk of ECI withholding, sellers will want to ascertain where they can give certificates and/or where the underlying GPs will give certificates. Toward that end, early in a sales process a seller will want to gather K-1's for each partnership (including each AIV) in which it is invested to document that the partnership has not generated ECI. Note that if a seller does not have three years of good K-1's it cannot provide that particular certificate, which can be particularly problematic when selling interests in non-U.S. funds that may never have generated K-1's precisely because they don't have a U.S. nexus. (The 1446 rules are very broad-reaching and would, for example, apply where a German seller is selling an interest in a Luxembourg fund that only invests in France to a Swiss buyer.)
Historically, GPs have not been particularly accommodating around transfers, but we are starting to see that shift. Even still, this is an issue for which a seller will want to prepare early in the process.
Please note that there can be other tax issues in secondary sales such as FIRPTA withholding (for non-U.S. sellers), the Chinese PN7 withholding regime and transfer taxes. For example, whereas a few years ago we would see parties argue against the applicability of PN7 withholding, more recently, its applicability hasn't been challenged, and assessing its applicability is now on the standard checklist of diligence questions for buyers of fund interests with Chinese exposure, and accordingly, it is an issue sellers will want to consider early in the sales process.
Isabel Dische: This is just a short distillation of some of the key issues a potential seller will want to keep in mind in advance of embarking on a sales process. Thank you, Emily, Alex and Dan, for joining me today for this discussion, and thank you to our listeners. For more information on the topics that we discussed or other topics of interest to the asset management industry, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we discussed—please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
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