GP-led secondary deals: to diligence or not to diligence?

June 24, 2022 – Lead buyers, new money investors and/or the general partner (GP) in GP-led secondary deals often only conduct limited legal due diligence of the assets (including any portfolio companies), typically focusing on capital tables and title, affiliate transactions and contingent liabilities, and compliance with law.

Unlike private equity mergers and acquisitions (M&A) due diligence, this process generally excludes the gambit of financial, tax, operational and transactional level due diligence, including labor and employment practices, environmental, real estate, material contracts, employee compensation and benefits, customers and suppliers, intellectual property, and other operational level matters.

Alignment theory

GPs and their counsel often justify the limited due diligence approach in GP-led secondary transactions on the theory that the GPs, who presumably know and understand the risks associated with the portfolio company and the transaction, possess the same incentives as the lead investor, rolling investors and any other new money investors to confirm the veracity of the representations and warranties. This assumes that by rolling all of their economics and interests from the existing fund to the continuation fund, the GPs expose themselves to the same down-side as the other rolling or new investors. As a result, GPs generally have similar incentives to the new and rolling investors to ensure that the transaction is fair and reasonable.

To put it another way, a GP has an incentive to ensure the assets acquired by the continuation fund do not come with any “landmines” or undisclosed material liabilities because the existence of any such value-eroding liabilities would also result in a value shift away from the rolling GP to the selling limited partners. Therefore, GPs argue there exists almost complete and perfect alignment between the GP, the lead investor, rolling investors and other new money investors in terms of disclosing and accounting for any material liabilities that would otherwise have been surfaced in a “deep dive” due diligence process.

Even in instances where the GP does not roll its entitlement in the existing fund to the continuation fund, GPs may still rely on the “alignment” argument on a theory that any “overpayment” on the part of the new and rolling investors could jeopardize the GP’s ability to receive its economics from the continuation fund (on account of an artificially high preferred return hurdle).

However, given the attenuated potential harm to the GP in this scenario, this presents a much weaker justification for the limited due diligence approach that dominates GP-led secondary transactions. Accordingly, in situations where the GP does not roll all or most of its entitlement in the existing fund to the continuation fund, a more in-depth due diligence review by lead investors and other new money investors may prove a more attractive value proposition.

Focus areas in a diligence-light approach

In deals where GPs and new money investors are aligned and there is justification for a limited “due diligence” approach, new money investors should still vet certain critical aspects, including:

•Verifying the fundamental representations to title and authorization are correct by confirming ownership and capitalization tables and comparing them to constitutional documents, incorporation documents, share registers and other similar back-up material. Although the GP can generally be trusted in this regard, given the magnitude of the adverse consequences if these representations are wrong, new money investors should always do their own independent verification in this regard.

•Confirming there are no transfer restrictions applicable at the portfolio company-level. This includes verifying with the portfolio company manager or management that the execution of the transaction qualifies as an “affiliate transfer” carved out from any transfer restrictions and, if not, seeking the issuer’s, governing body’s or, to the extent applicable, third party, consent to the transfer of the interest to the continuation fund. In addition, portfolio company-level documents can sometimes include restrictions on transfers such as rights of first refusal, rights of first offer and provisions preventing transfers to certain “competitors.” Often the GP will provide a summary or report of their findings in this regard, but without verifying such analyses, new money investors risk accretive assets dropping out of the portfolio due to portfolio company-level restrictions (leaving only dilutive assets being transferred to the continuation fund).

•Reviewing affiliate transactions agreements. This becomes particularly important given the conflicted nature of fund structures and GP-led transactions. New money investors must, as a matter of course, request all affiliate transaction agreements and conduct a review of the material provisions of agreements to ensure, among other things, there are no portfolio level fees paid to the manager upon consummation of the transaction.

•Contingent liabilities and legal compliance. These can become so-called “show stoppers” in any transaction, and particularly where a GP-led secondary consists of a single-asset deal or otherwise highly concentrated portfolio, a material contingent liability or legal problems with respect to any material asset could dramatically alter the value proposition. Since the GP is already faced with the potential adverse outcome of such matters, their risk tolerance and how they discount the liability may differ significantly from a new money investor. As such, it is imperative that a new investor independently analyze any material contingent liabilities or legal compliance issues as part of the due diligence process.

While more detailed diligence in these deals is not always necessary, new money investors should still seek confirmations from the GP on the typical due diligence elements, such as acceleration provisions in lender and management agreements, regulatory approvals and notices and other material agreements or relationships that could be impacted by the transaction.

Additional specific issues requiring closer scrutiny

There are certain instances where the GP may have less incentive to conduct appropriately rigorous due diligence beyond those situations where the GP does not roll a significant portion of its economics as part of the deal. For example, the GP may not want to conduct a deep dive of the assets to protect itself and the value attributed to the deal if there is a liability or issue that is already destroying value regardless of whether the transaction closes (e.g., preexisting environmental liabilities, known weaknesses in accounting or compliance procedures, data security lapses, or other previously identified material contingent liabilities).

Because it is difficult to identify these assets, issues or liabilities without conducting a deep-dive analysis, the industry or transaction type itself can serve as the red flag indicating areas or instances where new money investors should conduct a deeper dive rather than simply relying on the GP’s due diligence or confirmations. For example, detailed analysis should be undertaken when portfolio companies require regulatory filings or notifications (including with the Committee on Foreign Investment in the United States, under the Hart-Scott-Rodino Act, or with any other U.S. or international regulatory agency) or operate in regulated industries (including health care, consumer food products or technology).

In addition, businesses that do significant government work, that involve potential environment liabilities (such as manufacturing waste management, petroleum/gas, natural resource extraction, etc.) or that employ significant numbers of union employees (e.g., media/entertainment, transportation, manufacturing, natural resource extraction, etc.) may also merit a closer look to get a more informed sense of compliance with the complex regulatory and procedural requirements and standards that have heightened importance for those industries.

Accordingly, new money investors should work with their advisors to identify key value drivers (and potential pain points) of the transactions, particularly with respect to assets operated in the foregoing industries. Together, they can map out an appropriate plan for enhanced but still relatively focused diligence on those specific areas (e.g., customer contracts, supply chain, ESG matters, pension liabilities, tax liabilities or other operational matters or portfolio company-level matters) to provide additional comfort and bridge any potential misaligned interests between the GP/management team and the new money investors with respect to the due diligence process.

Fadi Samman is a regular contributing columnist on investment funds for Reuters Legal News and Westlaw Today.

Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.