Debevoise on Material Omissions in Private Equity Secondary Transactions

As private equity funds approach the end of their lives, a fund’s general partner is often encouraged by the fund’s limited partners and third-party buyers to consider secondary liquidity solutions. Liquidity solutions can involve fund extensions, asset sales to third-party buyers, tender offers to limited partners, or other creative structures to maximize value in remaining fund assets. When properly executed, these structures can satisfy all stakeholders by allowing some to realize value while others remain invested in the assets. These structures, however, can be rife with conflicts of interest. A vivid example of the possible pitfalls—and the vigilance of the Securities and Exchange Commission regarding fair disclosure—can be seen in the September 7 settlement of an administrative proceeding and fine against VSS Fund Management LLC (“VSS”). VSS was alleged to have failed to provide the limited partners of a private equity fund it advised, VS&A Communication Partners III, L.P. (“Fund III”), with material information relating to a change in value of the assets of the fund in connection with a secondary offering led by Jeffrey T. Stevenson, the owner and managing partner of VSS. [1]

Background. In April 2015, when Fund III was in its 17th year and held two remaining portfolio companies, several limited partners informed the manager of their desire to exit. The VSS investment committee, of which Stevenson was a member, decided to dissolve Fund III through an in-kind distribution. At the same time, Stevenson proposed that he would purchase the limited partners’ interests at a cash price based on Fund III’s December 2014 audited NAV. When presenting this offer to Fund III’s limited partners, VSS stated that the 2014 EBITDA of both of Fund III’s two remaining portfolio companies had declined from 2013 and that VSS had not pursued a sale of the investments due to the “recent down performance of the business.” The vast majority of Fund III limited partners promptly accepted the April offer. In early May 2015, the VSS investment committee received updated first-quarter financial information from the two portfolio companies, which led to a material increase in Fund III’s NAV for that quarter.

By mid-May 2015, VSS decided to leave Fund III open rather than distribute its assets. VSS notified Fund III’s limited partners that it no longer planned to do an in-kind distribution but that Stevenson would still be willing to purchase limited partnership interests at the same cash price offered in April. Notably, however, VSS did not inform limited partners of the potentially significant increase in Fund III’s value. More than 80 percent of limited partners accepted the offer to buy their interests. By June 2015, VSS’s  internal valuations continued to show a potentially significant value increase in value, and the information continued to be withheld from limited partners even though VSS was required to provide financials to limited partners within 60 days of quarter end. No explanation was given for the delay of Q1 2015 financials which would have shown the material increase in Fund III’s value.

Based on these facts, the SEC found that the failure of VSS and Stevenson to disclose the potential increase in value was a material omission. In particular, VSS’s uncorrected statements about the portfolio companies’ declining EBITDA and “recent down performance” became misleading. By presenting Stevenson’s offer “as an accommodation” with the same purchase price as the prior offer, the new offer appeared to provide limited partners with the full value for their interests; yet VSS and Stevenson had preliminary information indicating the value of Fund III had potentially increased significantly from the 2014 NAV. As a result of these actions, VSS violated, and Stevenson caused VSS’s violations of, Section 206(4) of the U.S. Investment Advisers Act and Rule 206(4)-8.

Practical Implications. The VSS settlement demonstrates the SEC’s continued focus on the conflicts of interest that can occur in several contexts. The increased popularity of general partner-led secondaries during the last few years means that more managers are facing situations where the valuation of a fund’s remaining investments will be a critical factor, particularly when the general partner seeks to increase its economic interest in the remaining investments. The SEC had previously demonstrated its focus on this issue in the Blackstreet case. While Blackstreet is more widely known for finding that the private equity firm was an unregistered broker dealer, it also involved a conflict of interest in connection with the acquisition of limited partnership interests by a controlling person of the general partner.[2] As both these cases show, full and transparent disclosure of all relevant information by the manager to existing and potential investors is the best way to ensure a favorable outcome for all parties.

ENDNOTES

[1] In the Matter of VSS Fund Management LLC and Jeffrey T. Stevenson, Investment Advisers Release No. 5001 (Sept. 7, 2018) (Administrative and Cease-and-Desist Proceeding), available here.

[2] See In the Matter of Blackstreet Capital Management, LLC and Murry N. Gunty, Investment Advisers Release No. 4411 (June 1, 2016) (Administrative and Cease-and-Desist Proceeding), available here.

This post comes to us from Debevoise & Plimpton LLP. It is based on the firm’s memorandum, “Buyers (and Sellers) Beware: Material Omissions in Private Equity Secondary Transactions,” dated September 18, 2018, and available here.