SEC Focus On Adviser-Led Secondaries Continues – Securities

Adviser-led secondary transactions have seen explosive growth
over the last five years. That growth has brought increased
regulatory concerns over the conflicts of interests inherent in
these transactions and a perceived lack of transparency into this
market. New SEC rules adopted in 2023 will arm regulators with
additional tools to identify, exam and investigate market
practices. It is therefore critical for managers running an
adviser-led secondary transaction to not only comply with the new
rules as they become effective but to structure any such
transaction with the SEC’s concerns in mind.

The SEC’s New Tools to Address Adviser-led
Secondaries

In 2023, the SEC adopted new reporting obligations and other
requirements for adviser-led secondary transactions. First, the
amended Form PF reporting obligations require SEC-registered
investment advisers (“RIAs”), within 60 days after the
end of each quarter, to report the execution of an adviser-led
secondary transaction in the prior quarter involving a
“private equity fund” (as defined in the Form). The first
filings were due by February 29, 2024. The adopting release to the
Form PF amendments makes clear that the
purpose of quarterly reporting is to “increase the efficiency
and effectiveness” of SEC examinations and investigations,
thereby informing its policy making and increasing investor
protection. Thus, the new Form PF reporting will likely lead to
greater scrutiny of adviser-led secondaries in the exam context and
could become the basis of future sweeps or targeted
examinations.

Second, the final Private Fund Adviser rules will require RIAs
conducting an adviser-led secondary transaction to obtain a
fairness opinion or a valuation opinion and prepare and distribute
a written summary of any material business relationships between
the adviser or its related persons and the independent opinion
provider. Although the Adviser-led Secondaries rule is part of the
ongoing litigation and does not kick in until
September 2024 (for larger private fund advisers) or March 2025
(for smaller private fund advisers), the SEC’s statements in
the adopting release (like the Form PF Release), provide critical
insights into the SEC’s concerns regarding these
transactions.

Specific Conflicts and Areas of Concern Raised by the
SEC

The adopting releases for both the Form PF and Adviser-led
Secondaries rules highlight the SEC’s particular areas of
concern, including:

• Heightened Risks: The Private Fund Adviser
  rules adopting release notes that adviser-led secondaries may be
  “particularly risky” based on the staff’s
  understanding that such transactions occur during times of stress
  where the adviser may be under pressure to restructure a portfolio
  investment or extend the fund’s contractually agreed upon
  term.




• Valuation of Assets: In support for requiring
  a fairness or valuation opinion, the release identifies the
  adviser’s potential incentive “to over- or
  undervalue the underlying asset depending on how they will receive
  the most compensation,” whether from the selling fund or from
  the continuation fund.




• Compensation: The release observes the
  potential conflicts arising from the ongoing compensation that the adviser would
  earn from the continuation fund: “Advisers stand to profit . .
  . by earning additional compensation in the form of management fees
  or carried interest which is ultimately paid by fund
  investors.”




• New Vehicle Terms: The release highlights that the potential conflicts
  “may influence or alter the terms the adviser sets forth in
  the new vehicle’s governing agreement to the detriment of
  investors.”




• Stapled Commitment: The release reiterates the
  staff’s prior concerns over stapled secondary
  transactions – if the secondary buyer is required to make a
  stapled commitment to another vehicle,
  “the price offered to the fund’s investors could be
  adversely affected if the staple requirement reduces the amount
  prospective buyers are willing to pay.”




• LPAC Consent: The adopting releases for both
  the Form PF amendments and the Private Fund Adviser rules raise the same
  concern that advisory board or LPAC consent alone may not be
  sufficient to address conflicts, with the former noting that
  “advisory boards are comprised of only the largest investors
  in the fund, and the adviser does not seek consent from the
  remaining investors,” and the latter even going so far as to
  assert that LPACs “may not have sufficient independence,
  authority, or accountability to effectively oversee and consent to
  conflicts or other harmful practices.”




• Informed Consent: Both releases likewise
  emphasize the need for informed consent, expressing concern in
  situations where limited partners are not given enough time “to adequately conduct
  diligence or negotiate the terms of the continuation fund before
  its election is due.”

Takeaways

One can debate whether the nature of, and the frequency with
which, these conflicts arise in adviser-led secondaries support the
SEC’s adoption of new reporting and procedural requirements,
given that adviser conflicts of interest were already covered by
the antifraud provisions of the Advisers Act in Section 206 as well
as Rule 206(4)-8. Nevertheless, these releases provide a roadmap of
the SEC’s concerns in these transactions. Even if the recent
rulemaking does not withstand the ongoing court challenges, the SEC’s views are
clear: Conflicts involved in these transactions must be disclosed,
informed consent must be obtained, and the SEC will be watching
closely to make sure that that happens.

To mitigate the regulatory risks in these transactions, advisers
should therefore be attentive to such things as asset valuations,
the structuring of compensation and new vehicle terms and the
completeness of the disclosures. Additional attention should be
placed on the consent process to ensure that limited partners have
complete information and adequate time to provide fully informed
consent. Notwithstanding an environment of greater SEC scrutiny and
ever-increasing consequences of getting it wrong, the risks can be
managed through deliberate processes and disclosures that bear the
SEC’s concerns closely in mind.

Read more of our Top Ten Regulatory and Litigation Risks
for Private Funds in 2024.

SEC Focus On Adviser-Led Secondaries
Continues

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