The shadow of the SEC is looming over the private equity secondary market.
SEC officials have been vocal about their scrutiny of zombie funds and the restructuring process. Agency officials have said at past conferences they plan to watch this area closely to make sure limited partners are being treated fairly.
In restructurings, new investors buy assets out of an existing fund and provide capital for a new fund to house the remaining portfolio companies — effectively helping a GP raise a new fund. Existing LPs in these deals usually get the option to either sell their stake in the old fund, usually at a discount, or roll their interest into the new vehicle.
Generally, these deals require approval of some percentage of the LP base, but in some cases approval can come from LP advisory committees.
Igor Rozenblit, co-head of the Private Funds Unit in the SEC’s Office of Compliance Inspections and Examinations, last year asked if managers were meeting their fiduciary duty when presenting investors with two bad options.
Rozenblit repeated his warning earlier this month at Private Equity International’s CFO and COOs Forum in New York. He said the SEC was watching zombie funds — funds that have lived beyond their contractual terms managed by GPs unlikely to raise new money. These funds may be “tempted to resort to creative approaches in markets that are less favorable,” so it is important that managers “make sure that those creative approaches don’t cross the line and violate federal securities law,” Rozenblit said, PEI reported.
SEC scrutiny appears to have influenced GPs trying to restructure their funds to make sure they offer a “do nothing” option for existing LPs, several secondary market sources told me. This means LPs who don’t want to sell out of their fund interests, but also don’t want to roll with the GP into a new fund structure with reset economics, can simply do nothing. The only real effect that can’t be avoided is essentially a fund extension, sources told me. The restructuring vehicles usually get two to five years to keep investing.
Several buyers on the secondary market said this is the way the industry is heading and it’s a good thing. Prior to this, the restructuring opportunity was like the “wild west,” one secondary source said. It was not well-trod territory, but a necessary evolution as funds entered their twilight years with no path toward final closure, just a series of extensions.
In the past, LPs who chose to roll with the GP into a new structure were forced to put up fresh capital to allow the GP to keep investing. That fresh capital aspect of these situations — called a staple — annoyed LPs and put them in a tough spot, especially if they didn’t want to sell.
But it’s not just SEC scrutiny that is helping to drive change: LPs have become more knowledgeable about these types of situations and are more vocal when a GP makes this type of proposal, sources said. The likelihood of a process getting completed that doesn’t take LP interests into consideration, or forces LPs to do something, is low.
Secondaries, a niche space in an already niche industry, is regulating itself, with some nudging from the big, bad agency looking over everyone’s shoulders. That’s a good thing because restructurings, recapitalizations and other ways of helping GPs and LPs deal with end-of-life funds is vital to making private equity a more complete market.
No word on whether the agency is actually investigating a restructuring. If you have any tips, hit me up.
Looming shadow photo courtesy of ShutterStock