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Managers of fund-of-funds are increasingly leveraging their relationships with GPs to build out secondary investing units.
Investment manager and outsourced chief investment officer Partners Capital, for example, has explored this strategy since appointing a head to build out its secondaries business in May, joining firms such as Hamilton Lane and HarbourVest Partners, which have had both businesses for years.
The benefits of branching from funds-of-funds to secondaries are clear for these managers: The primary business has established relationships with managers and visibility into the funds and assets that the secondary units invest in.
But as the number of groups with both businesses grows, so does the potential for conflicts of interest. This is particularly so when you throw another inherently conflicted element into the mix: a continuation fund.
Funds-of-funds might hold small stakes in dozens of other private equity vehicles, with underlying exposure to hundreds of companies.
People that PitchBook consulted for this piece say they have seen instances where a fund-of-funds is a limited partner in a fund that rolls one of its assets into a continuation fund, with its own secondary arm buying into that vehicle.
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“It is sort of inevitable when you operate at a certain scale that you’re going to be on both sides,” said Alex Zeizel, a partner at law firm Proskauer, where she advises on secondary transactions. “I certainly see it happen fairly frequently with large buyers.”
In such cases, the funds-of-funds arm has a fiduciary duty to drive the highest price possible for its investors. Meanwhile, the secondary fund doesn’t want to overpay for its spot in the continuation vehicle of that asset.
“I think this will happen more as more fund-of-fund investors get involved,” said Krishna Skandakumar, co-chair of the private funds transactions group at law firm Debevoise & Plimpton.
Seasoned secondary buyers have developed legal safeguards to protect against conflicts of interest in deals where the firm is an LP and a buyer into the continuation fund, Skandakumar said. Importantly, most conflicts of interest in these processes aren’t unlawful; they just need to be disclosed to investors.
“They’re very alive to this, and they have spent a lot of time on disclosures,” he said.
Still, poor management of conflicts of interest in a deal where one firm is both a seller and a buyer of an asset can leave the process vulnerable to abuse.
In most cases, limited partnership agreements allow LPs to act in their own self-interest without a fiduciary responsibility to the other investors in the fund, according to secondaries lawyers. This applies even to members of the limited partnership advisory committee. It’s therefore kosher for an LP to point out potential deals and continuation fund opportunities to the secondary investment team in its own organization.
To guard against conflicts, a GP will hire an intermediary—an investment bank—to conduct a third-party review of the process and execute the sale to the highest bidder. The primary fund’s LPAC is then responsible for waiving any conflict related to the intermediary’s process.
Even with apparent safeguards in place, lawyers said some processes are shoddily run, with GPs hiring investment banks that don’t cast a wide net for bidders or provide little insight into how the winning bid was selected.
“Have I seen people running a very light, quick process just to have had an intermediary? Of course,” said Gabriel Boghossian, a partner at law firm Stephenson Harwood.
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Institutional Limited Partnership Association director of industry affairs Brian Hoehn said opaque bidding processes for continuation funds are a consistent frustration for LPs. Poorly run processes and limited disclosures pose threats to the LP-GP relationship, he said.
“Almost all LPs today would tell you that they want to see GPs providing more information about the bidding process in these continuation funds,” he said.
This includes information about the bank selected for the process, the alternative exit routes considered, pricing details and why the winning bid was selected.
In 2023, the Institutional Limited Partnership Association issued guidance that recommends GPs provide LPAC members with enough information to evaluate whether the transaction was structured appropriately to determine a fair price. It also recommends the GP disclose the existence of any LPAC members who are acting as bidders and that they should “recuse themselves where appropriate.”
This will become increasingly important as more fund-of-funds managers take the plunge into secondaries.
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