Negotiating market price, fund economics, management and other investors, documents, and approvals are key to leveraging fund-to-fund transfers.
Following significant fundraising activity, sponsors have substantial capital at their disposal. However, in Europe, there were 564 deals worth US$72.8 billion in the first half of 2019, the lowest volume since the first six months of 2009. Amid the struggle for high-quality transactions, more sponsors are focusing on existing assets, and utilising fund-to-fund transfers to retain prized portfolio investments. Multiple buyout firms have pursued fund-to-fund transfers so far this year — but achieving a deal that balances the interests of those involved can bring challenges. Further, as fund-to-fund transfers become more common, parties are likely to focus more closely on their rights in a potential fund-to-fund transfer scenario.
While each deal is unique, in our view, deal teams must carefully navigate the following key issues.
Establishing a Market Price
While there may be significant overlap, the investors (the LPs) in the selling fund and buying fund will be different and invested in different proportions. The sponsor (the GP) owes fiduciary duties to all of its LPs, and needs to balance the competing interests of the old and new LP constituencies. To ensure a fair outcome, an arm’s length auction process is typically run. Deal teams must ensure that where an auction is run, potential third party buyers know that it is a genuine process — they may be reluctant to incur the expense of participating if they suspect that the purpose is merely to set a price for a fund-to-fund transfer.
Offers received from independent third parties then provide a benchmark against which the price (and other terms) offered by the buying fund can be tested. In addition, the GP may seek to bring in a third party minority investor alongside the buying fund. The involvement of the minority investor, frequently a pension fund or sovereign wealth fund, provides additional validation for the valuation and terms offered to the buying fund.
Agreeing the Fund Economics
The transfer is likely to be a crystallisation event for the GP’s carried interest in the selling fund. LPs in the buying fund may want the GP to demonstrate conviction in the investment by agreeing to reinvest a portion of that carry as a co-investor, alongside the buying fund. LPs in the selling fund may expect to be given the opportunity to “roll” their existing investment into the new deal, becoming co-investors alongside the buying fund. If so, agreement will need to be reached on the fees payable by any LPs that elect to take up that offer i.e., whether they should pay the same fees as the LPs in the buying fund, or reduced fees, or whether they should be entitled to co-invest on a “no fee, no carry” basis.
Dealing With Management and Other Investors
The impact on any other investors in the relevant portfolio company also needs to be considered — in particular, whether drag or tag rights will apply, whether vesting of management incentives will accelerate (if applicable) and whether management will continue to be adequately incentivised. Given the increasing number of minority sell-downs we are seeing, we expect incoming minority investors to be much more focused on the terms of any affiliate transfer and drag provisions in the existing investment documentation, to ensure their commercial interests are protected on a fund-to-fund transfer.
Transaction Documents and Approvals
The transaction documents for a fund-to-fund transfer will be essentially the same as for a transfer to a third party, and parties should remain alert to frequently encountered issues. Parties should also be alert to deal issues that can result in recourse to the seller, such as leakage covenants and share title warranties. While fund-to-fund transfers are not dissimilar to other sponsor-to-sponsor deals, in which recourse is limited and entities are typically wound up promptly post-closing, parties will be keen to avoid a situation in which one fund is claiming against another. Finally, deal teams should note that the terms of any fund-to-fund transfer are also likely to be scrutinised by, and to be subject to the ultimate approval of, each fund’s LP advisory committee. The need for approval should be factored into the deal process.