Direct secondary transactions in the US

July 2013 | PROFESSIONAL INSIGHT | PRIVATE EQUITY

Financier Worldwide Magazine

An increasing number of funds are being raised with the mandate to focus on secondary purchases of assets from funds, institutional investors, founders and management employees. Direct secondary purchases of equity are increasingly being used by these funds alone, or in conjunction with other transactions, to provide exit opportunities for the holders of these securities. This article discusses some of the unique factors associated with direct secondary purchases in the US.

Uses of direct secondary transactions

Direct secondary purchases are purchases of illiquid equity interests in a private company directly from a holder of the securities, such as a fund, an investor, a founder or a member of management. Direct secondary transactions differ from the secondary market for limited partnership interests, because there is a sale of a directly held ownership interest in a company rather than a transfer of a fund interest or indirect ownership stake. Direct secondary transactions can be for the sale of an investment in a single company or of investments in an entire portfolio of companies.

These types of transactions can be used by founders, employees and funds to obtain some liquidity in otherwise highly illiquid securities and to take some profit before a complete exit event of the applicable underlying portfolio company. As the length of time from investment to liquidity event in venture funded companies has gotten longer, and as many private equity funds have been unable to achieve exits in their anticipated timeframe, direct secondary transactions can: (i) provide boards of directors the ability to incentivise management to continue working towards an exit by allowing management to take some profit prior to a liquidity event; (ii) give founders an opportunity to obtain liquidity in their positions prior to a liquidity event; (iii) allow funds that have reached the end of their lifecycles without exiting all of their private portfolio investments to liquidate their positions; (iv) allow general partners of funds to liquidate investments in portfolio companies in connection with changes in partnership structures; and (v) provide venture funds with the ability to obtain needed liquidity to support other portfolio investments or to free up capital to grow their portfolio.

The market for direct secondaries for these types of sellers is likely to increase in coming years due to a number of factors. Investors, founders and employees are increasingly aware that there are alternative options to a single full company liquidity event. They have seen the markets for secondary sales that have developed for large, high profile companies like Facebook and Groupon and have increasingly sought the same type of liquidity for their smaller company equity interests. In addition, venture-backed companies are often taking longer to reach a liquidity event. Accordingly, boards of directors, concerned that management’s incentive to continue working hard may wane, have increasingly allowed management to take some of the profits they have earned through direct secondary transactions. These types of direct secondary transactions may begin to rise as the private equity and venture investments from the large cohort of 2006 and 2007 investment vintage age without achieving a liquidity event during their expected investment horizon.

Purchasers that participate in the direct secondary market include a variety of funds. Some funds make direct secondary purchases from funds in which direct secondary transactions may be used in conjunction with purchases of limited partnership interests from fund investors or in a repositioning or restructuring of the general partnership in order to position the selling fund group for future fundraising activities. Some funds focus on large institutional secondary sales, which may include secondary direct transactions, and some funds specialise in direct secondary transactions with individuals such as founders and management employees and venture capital investors.

Issues in direct secondary transactions

Direct secondary purchase transactions from founders, management or investors can have some unique issues. The purchase transaction is typically exempt from the registration requirements of the US Securities Act of 1933 under the so called ‘4(1½)’ resale exemption, for resales of restricted securities. Valuations for securities sold in these types of direct secondary transactions vary with the specifics of the company and transaction structure, but typically reflect a 20- 40 percent discount from the current fair market value of the securities. Factors contributing to discounts may include discounts for minority interests and the illiquidity of the securities as well as the security’s terms and priority and liquidation preferences relative to the company’s other outstanding securities. Transaction terms can also be structured to address valuation terms, such as providing for payments to sellers in the event the purchaser receives returns in excess of negotiated thresholds (i.e., after a 3x return to buyer, all additional proceeds are split 25 percent to seller and 75 percent to the buyer).

Purchasers in direct secondary transactions generally do not have the same negotiating power with respect to investor rights, such a board seats or veto rights, as they are not making a purchase directly from the issuer of the security. Consequently, direct secondary purchasers typically receive only those rights which the seller holds. The purchaser’s ability to obtain even these rights will also depend on the transferability of rights under applicable stockholders agreements, organisational documents and any other contractual arrangements the issuer of the security has made with the seller. For many funds making direct secondary purchases, the most important investor right is adequate information rights about the company.

A right of first refusal under a stockholder agreement can, if not dealt with properly, upset a direct secondary transaction. To avoid losing a deal to a right of first refusal, many direct secondary purchasers will want to discuss the proposed sale with significant stockholders and the issuer as part of the due diligence process in order to get a sense of pricing perceptions, stockholder appetite for the securities and to assess the likelihood that a right of first refusal could be exercised. If right of first refusal is exercised after notice of a proposed sale in a direct secondary transaction, the direct secondary purchaser would be unable to purchase some or all of the desired shares, after having spent time and money on due diligence and negotiating the deal. In many cases, a waiver of the right of first refusal is sought in connection with a secondary direct transaction.

Due diligence by direct secondary purchasers is often much less extensive than the due diligence done by investors purchasing securities in a new round of financing or in an initial purchase transaction. Non-disclosure agreements with the portfolio company are typically necessary in order for the direct secondary purchaser to get information from the selling stockholder about the company. Company cooperation is important in a direct secondary transaction because stockholder agreements can often require sellers to obtain a variety of company consents, such as board of director or shareholder consent to the sale of the stock, and legal opinions from outside counsel as to the permissibility of the sale under applicable securities or tax laws. The company and the seller may need to cooperate in connection with providing notices and obtaining any consents in connection with a right of first refusal or getting any waivers therefrom. Effective communication and cooperation from the portfolio company can be essential in effecting a direct secondary transaction.

The legal documentation for the sale of the securities will vary depending on the structure and terms of the transaction. Sale agreements typically include representations from the seller as to ownership of the stock and investment representations from the seller. Purchasers are likely to get very few, if any, representations from the company in any transaction documents in a direct secondary transaction.

Michael B. Gray is a partner at Neal, Gerber & Eisenberg LLP. He can be contacted on +1 (312) 269 8086 or by email: mgray@ngelaw.com.

Michael B. Gray

Neal, Gerber & Eisenberg LLP