Considerations For Institutional Investors Contemplating A Secondary Sale – Financial Services

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With 2023 upon us, here are a few considerations for
institutional investors contemplating a secondary sale,

  • Why an investor may want to pursue a secondary sale;

  • Typical deal processes;

  • Considerations for LPs;

  • Reducing deal execution risk; and

  • Key tax considerations.

Why an investor may want to pursue a secondary
 A few factors have led LPs to consider
secondary sales in recent months, including

  • Macro concerns. Perhaps at the top of the list
    is a question of portfolio allocation: given the divergence between
    public and private market valuations (the latter tend to lag the
    former), a number of institutional investors have found themselves
    over-weighted to private exposures. Depending on the parameters of
    an investor’s investment program, it may be under an
    obligation to rebalance its portfolio to correct that skewing.

  • Fundraising/ exit mismatch. Another factor
    that has driven some of our investor clients to consider secondary
    sales recently is the divergence between fundraising timelines and
    exits from prior vintages, which is only exacerbated as fund sizes
    grow larger. Put another way, some LPs may need to realize current
    positions to have capital to deploy to new funds.

  • Rebalancing. LPs also may want to rebalance as
    part of their normal course reevaluation of their
    relationships—for example, as part of a program to
    concentrate their exposures with favored sponsors.

Secondary sales process. Private fund interests
are by their nature illiquid assets, however, so rebalancings are
more involved than simply calling a broker and placing a sell
order. A potential seller will need to find a buyer, negotiate a
purchase agreement, and then negotiate the transfer agreements with
each of the underlying funds being sold. Each of these steps takes
time and, because most funds only process transfers on a quarterly
basis (but in some cases only semi-annually), it may be many
months, or even longer, between when a seller starts a secondary
sale process and when the deal closes.

Engaging a broker? As a first step, a
potential seller will need to decide whether or not it wants to
engage a broker. What makes sense will depend on the parameters of
the transaction contemplated. For example, if an LP is selling only
a single fund interest and the fund in question has a list of
approved buyers, a broker may not make sense (presuming the
LP’s comfortable taking on the work of interfacing with those
potential buyers).

Conversely, if an LP is looking at a larger sale, a broker can
add real value both in terms of managing a more complicated process
with numerous buyers and helping navigate an optimal “sale
mosaic”—that is, figuring out how to divide up the
portfolio across multiple sales in order to maximize the overall

Brokers can also provide a sense of indicative pricing which can
help a seller evaluate its options and can help with the sales
process itself, which can be fairly time
consuming—confidentiality agreements, various confirmations
with the GPs, establishing a data room, communications with
potential buyers, chasing GPs on transfer agreements, etc.

Reducing deal execution risk.  With or
without a broker involved, there are a few steps a seller can take
to make a sales process go more smoothly:

  • Core documentation. First, in tandem with any
    preliminary discussions about the potential sale, it behooves
    sellers to start gathering copies of the core documentation buyers
    will want to see—LPAs and any amendments, capital account
    statements, side letters, sub docs, details of any AIVs through
    which the seller is invested. Any non-U.S. sellers will want to
    gather the last three years’ K-1s and other tax forms the
    seller may have received from the underlying funds. Sellers also
    will want to understand from each GP what they can share with
    potential buyers so the seller doesn’t breach its
    confidentiality obligations.

  • ROFR. Sellers will want to check earlier in
    the process rather than later whether there are any rights of first
    refusal, as the mechanics of a ROFR process can delay closing.

  • PTP considerations. Sellers will also want to
    check whether the GP will delay transfers for publicly traded
    partnership (or PTP) reasons. We’ve seen some GPs impose PTP
    delays of several years.

Typical deal processes. In a typical sales
process, sellers will solicit bids, sign an LOI with the preferred
buyer or buyers and then negotiate the purchase and sale agreement
(or PSA). Brokers can be particularly helpful at the bid stage of a
deal where a seller’s selling a larger portfolio of funds, as
they can provide guidance on which funds are comparative
“gems” or “dogs,” and guidance on how
interests may be grouped so as to maximize the overall price. For
example, a potential buyer may be willing to pay more for a
particular interest if buying only a part of that interest, or
requiring buyers to buy a “dog” if they want to
purchase a “gem” might make more sense.

Note that for larger portfolios, it is increasingly common for
sellers to “mosaic” the sale to maximize the overall
pricing—selling different parts of the portfolio to different

Once the winning buyer (or buyers) has been chosen, a seller
will want to decide whether or not to sign a letter of intent with
the buyer. While secondary LOIs are fairly short, a seller will
want to make sure that the buyer has not included anything
problematic. For example, we’ve seen buyers include a
condition that none of the funds being sold is blocked, even when
buying from a non-U.S. seller. LOIs also often include exclusivity
provisions which limit the seller’s ability to engage with
other buyers, and even if conceptually acceptable, particularly for
mosaic sales, those provisions can introduce issues for a seller if
not drafted properly.

Typically, sellers provide the first draft of the PSA. One way a
seller can try to take advantage of the competitive bid dynamic is
to ask potential buyers to provide PSA comments in connection with
their bids, as buyers may be more restrained with their comments
when they are trying to “win” a deal.

Typically, parties wait to negotiate transfer agreements until
after the PSA is signed, but timing may drive the negotiation of
both in tandem as most funds will only permit transfers at
quarter-end (or in some cases, only semi-annually).

Tax considerations.   Secondary sales
involve a number of tax issues, in particular, for non-U.S.

Due to an unfavorable court ruling in 2017, the U.S. government
amended Section 1446 of the Code to clarify that the sale of an
interest in a partnership with a U.S. trade or business by a
non-U.S. seller was taxable, and to impose withholding requirements
on the buyer and the underlying fund with respect to partnership
interest transfers. The regulations generally require withholding
whenever the seller or underlying fund cannot, or in the case of
underlying funds will not, provide appropriate certificates. As an
example, while many sellers will be able to provide an exemption
certificate based on the representation that their last three K-1s
from an underlying fund reflect minimal or no ECI, if the
underlying fund has not existed long enough to provide the seller
with three K-1’s, or the fund has such limited contact with
the U.S. that it does not issue K-1s, this exception does not

As of January 1, 2023 funds now have a withholding obligation on
distributions to a buyer if the buyer (who has primary withholding
responsibility) does not properly withhold on the seller. As a
result, buyers will want to make sure that sponsors of the funds in
which they are buying interests agree with their withholding

We expect that this fund withholding obligation will force funds
to increase their involvement in the transfers. It certainly has
created a bit of fear in the buyer community as to the extent a
sponsor withholds on distributions to a buyer, that withholding
would generate a tax credit for the seller, not the buyer. (Note,
too, that a partnership can withhold even if the relevant
certificates are otherwise in good order, so buyers and sellers
will want to make sure underlying funds agree with their

Generally, the withholding obligation is 10% of the amount
realized on the transfer, but that amount realized includes not
only the purchase price, but also the seller’s allocable
share of fund liabilities. The amount of assumed liabilities is a
figure that can change practically daily. The Treasury Department
has helpfully clarified that a buyer will not need to withhold more
than 100% of the purchase price.

Because of the risk of ECI withholding, sellers will want to
ascertain where they can give certificates and/or where the
underlying GPs will give certificates. Toward that end, early in a
sales process a seller will want to gather K-1’s for each
partnership (including each AIV) in which it is invested to
document that the partnership has not generated ECI. Note that if a
seller does not have three years of good K-1’s it cannot
provide that particular certificate, which can be particularly
problematic when selling interests in non-U.S. funds that may never
have generated K-1’s precisely because they don’t have
a U.S. nexus. (The 1446 rules are very broad-reaching and would,
for example, apply where a German seller is selling an interest in
a Luxembourg fund that only invests in France to a Swiss

Historically, GPs have not been particularly accommodating
around transfers, but we are starting to see that shift. Even so,
this is an issue for which a seller will want to prepare early in
the process.

Please note that there can be other tax issues in secondary
sales such as FIRPTA withholding (for non-U.S. sellers), the
Chinese PN7 withholding regime and transfer taxes. For example,
whereas a few years ago we would see parties argue against the
applicability of PN7 withholding, more recently, its applicability
hasn’t been challenged, and assessing its applicability is
now on the standard checklist of diligence questions for buyers of
fund interests with Chinese exposure, and accordingly, it is an
issue sellers will want to consider early in the sales process.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.


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