Private Equity’s ‘Fourth Exit’ Crimped by SEC Plan, Lawyers Say

Investment lawyers worry the Securities and Exchange Commission will soon finalize a rule that would raise prices for a private equity alternative to sales and IPOs, making the tool less attractive to use.

The proposal would require fairness opinions before investors create so-called continuation funds. The funds let investors hold assets longer than anticipated as they await a better time for a sale or initial public offering.

Kirkland & Ellis often counsels clients to get fairness opinions, though an estimated $200,000 or $300,000 cost for one is not always worth it, especially for smaller funds, said Mark Boyagi, an investment funds partner at the firm. Requiring opinions could discourage use of continuation funds, he said.

“Mandating them is probably a step too far,” Boyagi said. “You’re going to be incurring incremental costs for no real value, and the only real value to it is having a piece of paper come exam time with the SEC.”

Continuation funds, also known as secondary funds, serve as an enticing holding pattern for investors in economies such as the current one where deal activity is down. High interest rates, tight credit, stepped-up regulation and a possible recession have caused a drop in asset sales and IPOs.

Leor Landa, the head of the investment management practice at Davis Polk, calls continuation funds “the fourth exit” in addition to mergers and acquisitions, IPOs or sales to other investors.

Demand for such vehicles shot up in the early stages of the pandemic to nearly $60 billion in 2021 from just over $20 billion in 2020, according to Campbell Lutyens & Co. Use of the structures dipped to $43 billion in 2022, the firm said.

Insight Partners raised $1.3 billion for a continuation fund to extend the life of investments in the software sector, the venture capital firm said in a statement Thursday. One Equity Partners raised $1 billion for a continuation fund for two portfolio companies, USCO and DWK Life Sciences, Bloomberg News reported May 10.

“You are definitely seeing an uptick in the amount of single asset continuation funds, particularly over the last five years,” said Jeff Fang, managing director and general counsel at equity management firm LSV Asset Management.

SEC Proposal

Under the SEC proposal, fund advisers must get an independent opinion as to the fairness of the price being offered in a continuation fund transaction. The SEC included the proposal with a half-dozen other planned private fund changes in February 2022.

The SEC should approve the changes “as soon as practicable,” Senate Banking Chairman Sherrod Brown, D-Ohio, told SEC Chairman Gary Gensler in a May 15 letter.

“Investors need increased transparency, more informative and useful data, and prohibitions on abusive and conflicted practices,” Brown said in the letter, also signed by seven other Democratic senators.

A decision on the rules package is in the pipeline, Landa said. “We’re expecting them to come through in the next few months,” he said.

Aisha Johnson, an SEC spokeswoman, said, “We don’t comment on the timing of regulatory actions.”

Landa said the fairness opinion proposal is “a little bit of a solution looking for a problem.” The buy side of continuation funds already knows when to push for opinions—and when such opinions would be too expensive to be worth it, he said.

It’s not clear a third party will provide a more reliable number for a continuation fund, said Robert Bartlett, faculty co-director at the Berkeley Center for Law and Business.

“They’re going to provide a range of values by which a transaction is fair,” Bartlett said. “That range is going to be susceptible to whatever assumptions they use in their model, and the assumptions are going to be potentially contestable.”

Potential Conflicts

Deciding the new valuation for an asset in a continuity fund can be convoluted, said Aaron Shapiro, co-president at LSV. For one, there’s a disconnect between what buyers and sellers want.

That makes it difficult for the parties to come to a price, especially in a market with depleted valuations and uncertainty. Continuation transactions “are rife with potential conflicts that have to be resolved, and that is one of the challenges,” Shapiro said.

The SEC proposal would require fund advisers to tell investors about any business relationships they had with fairness opinion providers going back two years.

“This requirement would provide a check against an adviser’s conflicts of interest in structuring and leading a transaction,” the SEC said in a fact sheet.

Brown and the senators said changes the SEC is seeking will “hold private fund managers accountable” and “help limit fraud enabled by the opacity and weak rulebook that characterize our private markets.”