By Fred Lee, Revelation Partners – Transactions led by GPs, including GP-led restructurings, are used as a tool for efficient fund management, benefiting both GPs and LPs. The volume of GP-led transactions has grown alongside volume in the broader secondary market. In 2020, GP-led deals accounted for USD26 billion of deal volume – more than 40 percent of total secondary activity.
There are several motivations for a GP-led fund restructuring. Most commonly, GPs seek to extend the fund’s life to manage the assets beyond the originally prescribed term and maximise the value of remaining fund assets. Restructurings may also provide access to additional capital, provide liquidity to existing LPs, realign the overall LP base, and reset GP economics. In 2020, fund restructurings into continuation vehicles (CVs) accounted for 73 percent of all GP-led secondary volume.
Potential benefits of GP-led fund structurings:
• Extend fund life
• Maximise the value of remaining assets
• Provide access to additional/unfunded capital
• Provide liquidity to existing LPs
• Realign overall LP base
Key components of the restructuring process include defining the deal structure, managing communications to existing LPs, ensuring proper legal documentation, and finding the right secondary partner.
Deal structure
A GP-led restructuring typically occurs when the remaining assets of a fund are rehoused into a new vehicle. The target fund will typically work with a secondary partner to purchase the fund’s assets for a negotiated price. Existing LPs are given the option to either:
• Sell their interest at the agreed-upon price;
• Roll their interest into a special purpose vehicle (SPV) established to purchase the assets of the target fund; or
• Some combination thereof.
The SPV will typically include new, unfunded capital from the secondary partner to support the portfolio assets. LPs that elect to roll into the new fund will be diluted by this unfunded capital component.
The SPV is typically managed by the existing GP of the target fund, although subject to a new partnership agreement. This agreement will provide for a number of “resets,” in terms of economics (carry and management fee), fund life, and follow-on capital commitment. As part of the reset economics, secondary partners and LPs will typically expect the GP to invest alongside in the transaction. This GP capital commitment is usually satisfied through a 100 percent roll of any after-tax carried interest proceeds that are realised as part of the transaction.
Each fund restructuring is unique, and as such, these specific terms tend to vary for each deal. Unlike a typical blind-pool fund, these terms are negotiated and customised to reflect the composition of the LP base, secondary partner, and requirements of the remaining assets (time and capital).
By restructuring into a new vehicle, the GP effectively extends the life of the fund. This relieves pressure on the GP to exit investments before key value-creation milestones have occurred, and in many cases, provides additional capital for both offensive and defensive investment opportunities.
Key considerations
The restructuring process can be complex, with multiple steps, decision points, and disclosures required. Properly managing key components of the process can assure a greater likelihood of success.
Asset Valuation: Pricing for a fund restructuring is highly-specific. A sophisticated secondary partner will account for many factors in determining the right asset valuation, including LP and GP dynamics, attractiveness of portfolio assets, portfolio concentration (across number of assets, sector, stage, etc), projected appreciation in asset value, future capital needs of portfolio companies, and timeframes for exits / liquidity.
Deal Process and LP Engagement: In April 2019, the Institutional Limited Partners Association (ILPA) issued guidance for both GPs and LPs, with four main procedural recommendations:
• When GPs initiate a restructuring process, the overarching objective should be to provide efficiency and transparency for all LPs;
• GPs should engage LPs as early as possible to provide rationale for the restructuring and any alternatives considered;
• The GP should provide detailed disclosures, along with sufficient time (at least 30 calendar days) for LPs to fully consider the terms of the proposed transaction; and
• GPs and LPs must have clear expectations around identifying and mitigating conflicts.
Tax Considerations: GPs should seek to maintain the same tax structure in the new SPV as the original fund, and operate the new vehicle in the same manner (i.e., short-term vs long-term gain considerations, use of tax blockers, etc). GPs should also maintain relevant tax protections for investors, such as avoiding unrelated business taxable income (for applicable tax-exempt investors). Lastly, LPs who roll into the new fund will typically receive a distribution in kind, to avoid an immediate tax liability. The GP should coordinate with existing investors prior to finalising the deal structure and rollover process; LPs may wish to consult with their own tax advisors to ensure alignment with the GPs approach.
Manager Economics: In most instances, the GP will seek “reset” economic rights for the new vehicle, including carried interest and management fees. Intended to incentivise individual managers to continue managing the portfolio assets, these economics are typically calculated based on the negotiated purchase price for the vehicle. However, in certain instances, including when the assets are sold at a steep discount to net asset value (i.e. an underperforming fund), rolling LPs may object to the lower cost basis for calculating carried interest. The GP may need to negotiate a customised waterfall, with certain tiers based on performance milestones (including gross multiple and/or IRR hurdles).
Finding the right secondary partner
Finding the right secondary partner is not only critical to a deal’s success, but also an opportunity to reshape the fund’s ongoing LP base. This has long-term ramifications for portfolio management and overall value creation.
A number of factors may complicate a potential restructuring process and necessitate a specialised secondary partner. The most common consideration is sector focus – for example, a portfolio of healthcare assets will require a partner with sector-specific expertise and alignment, as opposed to a generalist. Other factors may include portfolio concentration or assets that are early-stage or distressed in nature. When evaluating potential secondary partners, fund managers should seek a dedicated partner who not only has the deal experience and financial wherewithal to complete a restructuring, but also the expertise to maximise both near-term and long-term value.
Fred Lee, Managing Director, Revelation Partners
Fred Lee is Head of Business Origination at Revelation Partners. With over 14 years of banking and investment experience, Fred focuses on identifying and reviewing new investment opportunities, as well as managing the firm’s industry relationships. Prior to Revelation Partners, Fred was a Managing Director in the Life Sciences Group at Bridge Bank, where he executed venture debt investments across all healthcare sectors. He began his career in Citi’s Healthcare Investment Banking group.
