Adviser-Led Secondaries and the SEC’s New Private Adviser Rules

On August 23, 2023, the United States Securities and Exchange Commission (the “SEC” or “Commission”) adopted rules and rule amendments (the “PFA Rules”) under the Investment Advisers Act of 1940 (the “Advisers Act”)1 that impose new requirements and obligations on investment advisers to private funds. In our prior blog posts on the PFA Rules, we briefly summarized the SEC’s additions to the regulatory landscape for private funds and provided a more detailed exploration of the new quarterly reporting requirements applicable to registered investment advisers. This post provides a brief overview of adviser-led secondaries, discusses some of the concerns with this structure and explores the new conditions under which adviser-led secondaries must now operate.

Overview of Adviser-Led Secondaries

As a fund nears the end of its term, its investment portfolio may include one or more assets that the adviser believes have material value yet to be realized, resulting in the adviser having to decide between taking advantage of currently available exit opportunities and having the fund retain the investment in anticipation of a future increase in value. In this scenario, some investors may have liquidity needs or portfolio rebalancing considerations that would make the disposal of the asset more favorable, while other investors may prefer that the fund continue to hold the investment and realize the anticipated future gain (even if that means extending the fund’s term and continuing to pay management fees and operational expenses). An adviser-led secondary offers a third option that can accommodate the varied priorities of the fund investors and the adviser.

In an adviser-led secondary, the adviser identifies one or more assets of an existing fund managed by such adviser (a “Legacy Fund”) that they believe would benefit from a longer hold period and/or additional capital (the “Retained Assets”). The adviser may then offer the Legacy Fund investors the option to either (i) sell their indirect interest in the Retained Assets and be treated as “Selling Investors”; or (ii) contribute some or all of their indirect interest in the Retained Assets in exchange for an interest in a newly formed vehicle (the “Continuation Fund”). The remainder of the Continuation Fund’s investor base typically comprises third parties that make capital commitments and initial capital contributions to the Continuation Fund (the “New Investors”). The New Investors’ initial capital contributions often fund the amounts owed to Selling Investors in consideration of the sale of their interests in the Retained Assets to the Continuation Fund.

Potential Concerns

Adviser-led secondaries are usually complex transactions requiring a material amount of underwriting by prospective investors. Unfortunately, prospective investors often have limited transparency regarding the Retained Assets as well as the economic rationale and potential conflicts related to the proposed transaction, and they are sometimes afforded limited time to evaluate their options—all of which further complicate matters. Even before the February 9, 2022, release of the SEC’s originally proposed private fund adviser rules (the “Proposed Rules”), adviser-led secondaries were already subject to increased regulatory and industry scrutiny. In its adoption of certain amendments to Form PF,2 the SEC noted several concerns regarding adviser-led secondaries, including the limited time investors often have to sufficiently perform diligence for the transaction. The Institutional Limited Partners Association (“ILPA”) also released guidance in May 20233 on certain best practices for advisers and recommendations for investors who are presented with the opportunity to participate in a continuation fund. Similar to the concerns raised by the Commission in both the Form PF Adopting Release and the PFA Adopting Release, the ILPA Guidance also identified the need for a sufficient amount of time to evaluate the proposed transaction, as well as transparency regarding both the business rationale for the transaction and any conflicts related to the process as key considerations for adviser-led secondaries.

In the PFA Adopting Release, the SEC affirmed its focus on conflicts of interest that result from the adviser being on both sides of the transaction. For example, while an adviser has obligations to its Legacy Fund, it may be incentivized to undervalue the Retained Assets so that the Continuation Fund can pay a lower purchase price that could in turn increase carried interest from the Continuation Fund to the adviser. Another potential conflict could occur when an adviser-led secondary requires a “stapled commitment” to another adviser-managed vehicle, which could result in a reduced price paid to the Legacy Fund—a fact that the adviser may not be inclined to disclose as it could result in the Legacy Fund investors objecting to the proposed price. The Commission intends for the new Rule 211(h)(2)-2 under the Advisers Act (the “Adviser-Led Secondaries Rule” or the “New Rule”) to address such concerns by providing “an important check against an adviser’s conflicts of interest in structuring and leading [adviser-led secondary transactions] from which it may stand to profit at the expense of private fund investors”4 and providing “investors with information that will enable them to make educated and informed decisions.”5

The Adviser-Led Secondaries Rule

Under the New Rule, an adviser must, prior to the deadline for investors to elect whether to participate in an adviser-led secondary transaction: (i) obtain and distribute to investors a fairness opinion or a valuation opinion from an independent opinion provider; and (ii) prepare and distribute to investors a written summary of any material business relationships that the adviser or any of its related persons have or have had with the independent opinion provider within the two-year period preceding the issuance of the applicable opinion.

Adviser-Led Secondary Transaction Definition. The SEC broadly defines an “adviser-led secondary transaction” as a transaction initiated by the adviser or its related persons that offers investors a choice between selling all or a portion of their interests in a fund and converting or exchanging those interests for interests in another vehicle managed by the adviser or its related persons. In the PFA Adopting Release, the SEC confirms that this definition will capture single asset transactions, strip sale transactions and full fund restructurings. However, the SEC confirmed several categories of transactions that would not be captured by the New Rule: (i) an adviser’s assistance in the secondary sale of an investor’s interest, unsolicited by the adviser, generally would not be viewed as “initiated by the adviser”; (ii) tender offers (which were captured by the definition of “adviser-led secondary transaction” in the Proposed Rules) to investors, as long as investors are not offered a choice between selling and converting/exchanging their interests in the applicable fund; or (iii) rebalancings or “season and sell” transactions between parallel funds.

Fairness Opinions; Valuation Opinions. The first prong of the New Rule requires an adviser to obtain and distribute to investors a fairness opinion or a valuation opinion from an independent opinion provider. The PFA Adopting Release does not provide any guidance regarding the form or content of a fairness opinion, other than to define it as “a written opinion stating that the price being offered to the private fund for any assets sold as part of the adviser-led secondary transaction is fair.” A valuation opinion is defined in a similarly general manner as “a written opinion stating the value (as a single amount or a range) of any assets being sold as part of an adviser-led secondary transaction.” Fairness and valuation opinions must be delivered by an independent opinion provider, which means a person that (i) provides fairness opinions or valuation opinions in the ordinary course of its business and (ii) is not a related person of the adviser. The New Rule requires the delivery of a fairness or valuation opinion prior to the due date of the election form for the transaction, while the Proposed Rules only required delivery prior to the closing of the transaction.

While the requirement to deliver a fairness or valuation opinion may initially appear to be somewhat onerous and expensive, opinions from independent third parties have been a feature of many adviser-led secondaries for some time and, in our experience, are reflective of industry-accepted best practices. However, as noted by the Commission in the Form PF Adopting Release, best practices “are not always utilized and, even when used, do not always ameliorate investor protection concerns.”6 As a concession to the concern that fairness opinions may be overly burdensome and costly, the Commission determined that under the New Rule, advisers may also obtain valuation opinions (which, in some cases, would be a lower cost alternative than a fairness opinion). The SEC also considered permitting advisers to determine price based on a market-driven discovery process, such as when the sale of a minority stake in the relevant portfolio investments has taken place, or when its shares are publicly traded; however, it ultimately declined to do so, in part, because such processes may not provide an accurate value due to factors like stale pricing, varying transaction sizes and volatility in market prices of publicly traded assets.

Disclosure of Material Business Relationships. The second prong of the New Rule requires an adviser to prepare and distribute to investors a written summary of any material business relationships that the adviser or any of its related persons have or have had with the independent opinion provider within the two-year period preceding the issuance of the applicable opinion. Similar to the content of fairness and valuation opinions, the Commission does not define what qualifies as a “material” business relationship. Instead, it states that such a determination will be a facts-and-circumstances analysis. However, the Commission noted that audit, consulting, capital raising, investment banking and other similar services would typically constitute material business relationships. The New Rule requires the disclosure of the provider’s material business relationships to apply to the two-year period before the issuance of the opinion, rather than “the prior two years” (as would have been required under the Proposed Rules), and such requirement captures new business entered into immediately prior to the opinion’s issuance. Similar to the opinion delivery deadline, the material business relationship disclosure must be made prior to the due date of the election form for the transaction, rather than prior to the closing of the transaction as originally described in the Proposed Rules.

Additional Protections. Commenters to the Proposed Rules suggested that the SEC take an even more expansive approach to protecting prospective investors in adviser-led secondaries, such as requiring advisers to use reasonable efforts to allow investors to remain invested on their original terms without the adviser realizing any carried interest on the sale of the underlying assets. Further, the ILPA Guidance discusses several best practices that are not addressed by the PFA Rules, including: (i) entering into a competitive process to ensure a fair price is obtained; (ii) providing a 30-calendar-day/20-business-day minimum timeline for investors to decide whether they will participate; and (iii) permitting original Legacy Fund investors to participate in the Continuation Fund without any change in economic terms. Interestingly, the SEC took an arguably more conservative approach and chose to focus on providing investors with greater transparency by mandating the delivery of fairness and valuation opinions along with the disclosure of material business relationships with the independent opinion provider. As compared to other aspects of the PFA Rules, the Adviser-Led Secondaries Rule is not, in our view, a major departure from industry-accepted best practices.

Application of the New Rule

The Adviser-Led Secondaries Rule only applies to private fund advisers that are registered (or that are required to be registered) with the SEC. Compliance is required: (i) 12 months after the PFA Rules are published in the Federal Register (the “Publication Date”); or (ii) 18 months after the Publication Date for advisers with less than $1.5 billion in private fund assets under management.

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1 Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Release No. IA-6383 (Aug. 23, 2023) (the “PFA Adopting Release”).
2 Form PF; Event Reporting for Large Hedge Fund Advisers and Private Equity Fund Advisers; Requirements for Large Private Equity Fund Adviser Reporting, Release No. IA-6297 (May 3, 2023) (the “Form PF Adopting Release”).
3 Continuation Funds, Considerations for Limited Partners and General Partners (May 2023) (“ILPA Guidance”).
4 PFA Adopting Release at page 187.
5 Id.
6 Form PF Adopting Release at pages 63-64.