In February last year, the US Securities and Exchange Commission signaled its intention to tighten regulations governing all GP-led secondary trades, including real estate transactions.
The most notable proposed rule is aimed at addressing the clear conflict of interest inherent in transactions where the GP is acting as both the buyer and the seller. It would prohibit a GP from completing an adviser-led secondaries transaction with respect to any private fund, unless they had first distributed a fairness opinion from an independent opinion provider to investors in the fund. In addition, the fairness opinion provider must disclose any material business relationships they have had within the last two years with any of the parties involved in the transaction.
A year on, secondaries managers and advisers have had time to digest the potential implications of the new regulations and consider whether they will address the issue in a proportional way, and whether there could be any unintended consequences. Few, if any, market participants have reacted to the proposed rules with dismay.
Most believe that the proposals signal how far GP-led secondaries have gained acceptance over recent years. “They show that the US regulator absolutely accepts that these transactions have become part and parcel of the maturity of the private funds ecosystem, while wanting to look out for investors’ best interests as well,” says Steven Cowins, co-chair of law firm Greenberg Traurig’s real estate fund practice.
The new rule aims to ensure that a transparent process has taken place to establish that a fair price has been offered to the existing LPs within a fund when a GP proposes creating a continuation fund, and they face the decision of whether to roll over their interest into the new vehicle or cash out.
While independent fairness opinions have been employed more frequently in real estate secondaries recently, they have not been universally adopted. Other approaches are also used to aid that process of “price discovery,” including using existing appraisals of value, and paying consultants involved in the deal to shop around other market participants to provide a valuation.
Institutional Limited Partners Association best practice guidance for GP-led deals already recommends commissioning a fairness opinion, notes Jarrett Vitulli, co-head of real estate capital advisory at investment bank Evercore. “Real estate has probably been a little bit behind private equity in terms of using fairness opinions on a consistent basis.”
Catching up
“In the cases where there is a fiduciary on both sides of the transaction, and it is categorized as a securities exchange, a fairness opinion is very common. But that is a small proportion of the overall real estate secondaries market,” says Warren Kotzas, a partner at New York-based capital solutions and advisory firm Park Madison Partners.
When a real estate joint venture is being recapitalized into a new vehicle, with all parties involved being sophisticated private institutions and investors, a fairness opinion is not essential to securing an optimal outcome for all parties, he argues.
“We don’t believe it is necessary to have a blanket requirement for fairness opinions”
Warren Kotzas, Park Madison Partners
“It can be part of an overall process that includes elements like high quality, transparent information; early communication with investors; involving qualified legal and tax counsel; retaining an adviser to run a marketing process; and then at the end, ultimately providing optionality to investors on whether they want to sell or roll over their investment.
“It is that process that addresses the conflict of interest issue. The fairness opinion typically comes in towards the end as a third-party review that can provide some comfort to the constituents of the integrity of the process, but it does not in itself solve the issue.”
Getting a fairness opinion adds complexity and expense to a transaction, notes Kotzas, and it may not be appropriate for all circumstances, for example when investors do not want to undertake a process that involves sharing confidential information about their assets with other market participants to inform an independent valuation. “We don’t believe it is necessary to have a blanket requirement for fairness opinions, but a high standard of care is certainly something that we welcome,” he says.
“The key is whether the regulations are flexible enough to capture all of this and allow managers to do what makes sense in each context. We wouldn’t want to see beneficial secondaries trades not happen because of technicalities and costs.”
Increased litigation?
Could fairness regulation lead to increased litigation around secondaries transactions in future? Cowins believes it is unlikely. “It could be argued that more parties involved and more documents gives you more to litigate over. But having that mandatory check and balance on the process probably means there is less likely to be litigation because investors will be more protected.”
Litigation is seldom a problem in the real estate secondaries market anyway, because of the nature of the transactions, observes Brian Di Salvo, a partner at Park Madison Partners. “In a well-run GP-led process, the goal is typically a win-win-win situation: for the existing investors, who have the option to continue to participate; the manager; and the new investors, who get exposure to attractive assets at scale.
“Everyone has slightly different goals, but they are all clearly communicated upfront. And everyone has more options to make better decisions. If these transactions are designed right, everybody ends up happy. And you don’t sue people if you are happy.”
The impact of the regulations in practice will remain unclear for some time to come, however. Cowins says he understands that because of a glitch in the software used to receive feedback from stakeholders, the SEC has extended the comment period on the proposals. Therefore, publication of the final regulations is unlikely for several months, and then they will not come into force until a further six- to 12-month period has passed during which those affected have time to prepare.
When the new regime is established, it will be unlikely to cause much disruption in the real estate secondaries market. Indeed, it could well be a positive development, argues Evercore’s Vitulli. “If you look at what has happened in other sectors like options and derivatives, the concept of standardization of disclosures has actually been helpful in growing the industry,” he says. “Knowing what the contours of a well-run transaction process look like generally makes everyone more comfortable, and will ultimately benefit investors.”
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