In this Ropes & Gray podcast, asset management partners Isabel Dische, Peter Laybourn and Adam Dobson, and tax partner Dan Kolb discuss single asset recapitalization transactions. They provide a brief explanation of what these deals are, followed by a discussion of the typical structure for these deals and certain considerations fund sponsors will want to keep in mind, as well as certain key tax considerations.
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 and co-head of our institutional investor practice. Joining me today are asset management partners Peter Laybourn and Adam Dobson, both based in our Boston office, and Dan Kolb, a tax partner based in our New York office. Today, we are going to be talking about single asset recapitalization transactions. We'll start with a brief explanation of what these deals are, and why a fund and its limited partners may want to pursue a single asset recap. We'll next discuss typical structures for these deals and certain considerations fund sponsors 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.
Adam, would you like to kick off our discussion with a quick overview of what exactly a single asset recap is?
Adam Dobson: Gladly, Isabel. Very briefly, in a single asset recapitalization, a fund sponsor sells some or all of its investment in a current portfolio company to a continuation vehicle that is managed by the same sponsor, but capitalized by a new investor base. Existing investors typically are given the option of either cashing out all or a part of their indirect interest in the asset or continuing their investment through the new continuation vehicle. These transactions can be attractive for fund sponsors and fund investors for a range of reasons. For example, a sponsor may have a firm conviction in a longer-term value creation thesis, but if the asset has already performed well and appreciated in value, fund investors may want to take cash off the table. A single asset recap can allow the sponsor to retain the exposure to an asset it likes while giving a nearer-term liquidity option to interested fund investors. This is particularly relevant under choppier market conditions such as we've seen in the past six months, where sponsors may worry the market isn't acknowledging an asset's value. Alternatively, the asset may require more follow on capital and/or a longer realization timeline than is available within the scope of the existing fund, and a single asset recap again can provide a mechanism for the sponsor to access that additional capital and time.
Peter Laybourn: Thanks, Adam. As you noted, there are a number of compelling business reasons that may prompt a fund sponsor to pursue a single asset recapitalization. For example, there are some considerations that sponsors will want to keep in mind when it comes to this. First, I think these transactions involve basically inherent conflicts of interest, so there's a sale from one sponsor's fund to another. And second, the sponsor will typically receive fee and carry from the continuation fund. Because of these conflicts, it is critically important to carefully navigate all of this, and depending on the terms of the existing fund's partnership agreement, the sponsor may need to go to the full LP base for approval, but it's also very possible that the sponsor may be able to have the conflicts blessed by the LPAC of the relevant fund. I also think a fund sponsor will want to check whether any other approvals are required, for example, if there's anything in an individual investors' side letters or if there are anything under the terms of the underlying portfolio company's shareholders agreement or other governing documentation. Which actually brings us to the question of the typical deal process for one of these transactions. As a first step, a sponsor typically will engage a placement agent to solicit interest from secondary buyers.
Isabel, maybe you can speak to the auction process and what considerations are top of mind for secondary buyers?
Isabel Dische: Certainly. Just to say it, in the first instance, sponsors also will want to evaluate whether to sell the asset outright as compared with pursuing a single asset recap. The pool of potential buyers will be different for a single asset recap than for an outright exit, as typically these deals have been the domain of secondary buyers as compared with other fund sponsors and corporates. The deal size—whether too large or too small—may further limit interest even amongst secondary buyers. These deals are also inherently more concentrated than a typical secondary transaction, which can hinder interest. Much as with the process for selling an asset to a third party buyer, the sponsor's agent will solicit interest from a number of secondary buyers in the first instance. With the diligence and bidding process, the pool of interested buyers will likely shrink. Having some level of communication with the fund's LPAC at each stage of the bidding process can also help make sure the direction of the deal structures and pricing being discussed are within the bounds that the LPAC supports, helping with deal certainty.
So what else can go wrong? Sponsors and the secondary buyers who capitalize the continuation fund need to navigate pricing dynamics. If they set the price too low for a high-quality asset, too few of the existing LPs may cash out their interests. Too high a price, and a fund sponsor may deter potential buyer capital or may find itself without a deal or with a deal that is only partially underwritten, meaning that there isn't enough buyer capital to buy out all of the LPs who want to sell. To avoid a partially-underwritten deal (which, not surprisingly, tends to be less popular with investors) a sponsor may solicit buyer dollars from a buyer syndicate and also may offer its existing investors the ability to invest in the continuation fund directly (versus only rolling their interest). It is worth noting that secondary buyers also want comfort on deal size, so even if a buyer may be able to underwrite a full deal, it may prefer to maintain a lower overall exposure. Both to address buyers' desire to limit their overall concentration and to allow funds and buyers to line up sufficient capital, we often see parties agree to have a syndication window after investors have delivered their elections to sell or roll.
Peter Laybourn: Key to navigating these issues from a fund sponsor's perspective is early and continuous communication with the LPAC of the fund and the limited partners. For example, I think it's often appropriate for the sponsor to get the LPAC to bless incurring expenses in pursuit of the transaction at a very early stage. So I typically recommend that a fund sponsor keeps the LPAC informed throughout the deal process, including explaining the decision to pursue the single asset recap, but also to solicit feedback on the key terms of the transaction (and that's basically to avoid a mismatch between the negotiated terms and what the LPAC views as acceptable, and also the basis on which the LPAC clears the conflicts). After the terms of the transaction are negotiated with the secondary buyer, the sponsor will typically want to adequately disclose the terms of the proposed transaction to investors, including giving existing investors access to comparable materials as were provided to the secondary buyers – a parity of information, if you will. The sponsor will also typically want to ensure that its investors have adequate time to evaluate whether to sell, roll, reinvest depending on how the deal is structured, and that evaluation period is typically at least 20 business days, although that could be extended under certain circumstances. Depending on whether the lead buyer is fully underwriting the transaction or not, the sponsor also may need to cooperate with the lead buyer to syndicate additional buyer commitments to acquire the full amount of the interests that are tendered. All in, the timeline for one of these deals can range from just a few months to quite a bit longer.
Adam, do you want to highlight some of the economic and other key business items that we often negotiate in these deals?
Adam Dobson: Of course. There are two key agreements in these transactions: The limited partnership agreement of the continuation fund, and a contribution, or purchase and sale agreement pursuant to which the asset is transferred from the existing fund to the continuation fund. Within the partnership agreement, the parties negotiate the key economic provisions—management fees and the carry waterfall—as well as how to handle follow-on commitments and expenses, dilution if existing investors do not have the same proportion of follow-on capital as the secondary buyers, governance, and other investment matters. The contribution agreement (or purchase and sale agreement) serves to transfer the asset from the existing fund to the continuation fund. It makes clear exactly what assets and obligations are being transferred (and which are not), contains a variety of representations regarding the transaction and the underlying asset, and sets forth the negotiated indemnity package for the deal. While the contribution agreement is formally between the continuation fund and the existing fund, the lead secondary buyers will be intimately involved in its negotiation, and the ultimate beneficiaries of any negotiated indemnity.
One thing to note is that these deals can be very tax-intensive as, among other things, funds may try to structure these deals to effectuate the roll on a tax-free basis and buyers may want to optimize how the asset is held based on their own tax status. Dan, do you want to highlight some of the potential tax considerations with these deals?
Dan Kolb: There are many tax considerations in these deals and the relative importance varies depending on the facts. On the fund sponsor-side, among other items, if the sponsor is rolling any portion of its interest, the sponsor will want to preserve tax-free treatment. The sponsor often also tries to provide rolling investors with tax-free treatment and to segregate the rolling and selling investors so as to avoid accidental allocations of seller's gain to the rolling investors. Further, in such transactions a great deal of effort is invested in limiting withholding liabilities for ECI and FIRPTA. Due to the broad nature of the new ECI withholding rules, investors with no ECI at all can easily be picked up. Sponsors must also consider how and whether to block ECI assets and whether to sell blockers or the underlying assets. Among other items, buyers will focus on avoiding any assumption of seller liabilities (including partnership audit liabilities and the ECI and CAI withholding liabilities) and will consider 754 and 6226 elections to step up acquired basis and push out historic audit liabilities. There are many other tax considerations, and notwithstanding the phrase "single asset recap," these deals often involve many, many steps, but the forgoing considerations appear in many deals.
Isabel Dische: Needless to say, there's a lot to consider, but single asset recaps can be attractive from the perspectives of fund sponsors, fund investors and secondary buyers alike. Thank you, Adam, Peter 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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