Institutional investors, funds-of-funds, family offices, and other private fund investors are considering the economic exposure to their investments from operational disruptions as a result of the COVID-19 pandemic. To help navigate the choppy waters of the volatile markets, global law firm Morgan Lewis has some key pointers for institutional investors regarding the pandemic’s effects on the private fund secondary market as well as advice on internal governance issues.
Because the public markets are so volatile right now, Morgan Lewis suggests institutional investors should review their portfolios to determine whether the market decline has resulted in an over allocation to illiquid investments. They should also consider whether a secondary sale may be warranted to rebalance their portfolios. Institutional investors need to examine whether investment restrictions apply only at the time of investment or whether certain restrictions have continuous application.
Because traditional secondary transactions are usually priced as a percentage of a seller’s reported capital account in the underlying funds as of an earlier quarter-end date, Morgan Lewis says overall market volatility may require fund managers to write down valuations in later quarters.
“Furthermore, there is often a delay from the time a purchase agreement is signed until a transfer closes,” Morgan Lewis says in one of its LawFlashes. “Accordingly, buyers may seek purchase price protection to mitigate downside risk of any further market disruptions.”
The firm said that protection can be in various forms, such as the insertion of a “material adverse change” closing condition in the purchase agreement, performing additional due diligence at an earlier stage, and delaying the signing of a purchase agreement or effectuating a simultaneous “sign-and-close” in order to mitigate the effect of market declines between the time a purchase agreement is signed and when it closes.
“As a result of the recent market disruption, the execution risk of consummating a secondary transaction has increased,” Morgan Lewis said, adding that sellers should consider ways to bind buyers at the letter of intent stage or to negotiate additional key terms of the purchase agreement prior to agreeing to any exclusivity rights in favor of buyers.
“Furthermore, sellers may seek additional diligence on the creditworthiness of buyers and whether they intend to finance the transaction through borrowings.”
The firm also said that if volatility causes difficulties in exiting investments, general partner-led secondary transactions, such as single asset restructurings, may be useful in providing liquidity in the market. However, it cautioned that social distancing, flight cancellations, and other travel bans may prevent buyers from performing the required diligence.
And if managers have difficulty fundraising while the market continues to move lower, they may require buyers to make capital commitments to new funds as a condition to approving transfers in existing funds.
Morgan Lewis also offered some suggestions for institutional investors to focus on with respect to internal governance.
- Internal approval process: If in-person meetings are not permissible or advisable, there should be alternate means available for investment committees and other internal approval bodies to meet and record their decisions.
- Document execution: Processes need to be in place to ensure that signatories remain available even if offices are closed. If original signed documents are required to close a transaction, resources should be in place to ensure that originals may be transmitted between locations.
- Investment obligations: If the offices are closed, an investor needs to be able to satisfy capital calls and receive distributions in cash and in kind. And if the ability to meet capital calls is restricted, close attention should be paid to the default provisions in relevant fund investment documents, including any cure provisions.
- Alternative investment restrictions: Institutional investors with mandated alternative investment restrictions and alternative asset allocation caps should ensure that they continue to comply with these restrictions and allocation caps.