Estimated reading time: 2 minutes
The article in brief:
- Related-party transactions between private equity funds and their portfolio companies are fraught with the potential to create significant issues between different groups of limited partners (LPs).
- Fairness opinions for such transactions can forestall such conflicts.
- Related-party transactions may involve moving a portfolio company from one fund to another, a new equity investment from one fund in a company held in another fund, or contractual agreements between portfolio companies held in two different funds.
- Valuation approaches associated with fairness opinions are mostly straightforward, though allocating value to different shareholder groups can require special knowledge and understanding.
Family conflicts can erupt over any number of different issues. Who’s going to look after an aging relative? Who’s expected to help pay for a milestone event such as college or a wedding? What happens when certain family members drift apart and ally themselves with different family members? And how is the estate divvied up when someone passes on?
Mishandle such situations, and pretty soon, nobody’s speaking to each other at Thanksgiving. In extremis, lawyers may be retained.
It’s not all that different for private equity sponsors with multiple funds. As they attempt to manage different vehicles with different vintages efficiently and equitably and keep the extended family of LPs amicable and out of court, they frequently encounter analogous issues.
Fortunately for private equity GPs, they have the option of bringing in an objective outsider to evaluate the situation and head off conflicts between related parties before they become full-blown feuds: They can seek out a fairness opinion.
Related-Party Situations That May Warrant a Fairness Opinion
Any time assets are transferred from a fund with one set of LPs to another fund with a different group of investors—or whenever a portfolio company from one fund merges, or otherwise enters a contractual arrangement with, a portfolio company in another fund—it may be considered a related-party transaction. In such cases, fairness opinions by two different independent providers, one on behalf of the first fund and another on behalf of the second, are a prudent step.
Among the most frequent scenarios to arise:
- When a fund is near the end of its legal life but has not found an exit for a particular asset, the GP may wish to close down the fund to save on administrative overhead. In such a scenario, it may be advantageous for a newer vintage fund (or a portfolio company in the newer vintage fund, or even the GP itself) to purchase the asset; after all, the investment team likely knows the asset, its value proposition, and what it will take to unlock that value, better than anyone.
- A portfolio company in one fund may wish to enter into a significant legal arrangement, such as a management contract with a company in another fund; investors may ask whether the arrangement is fair or favors one party or the other.
- A portfolio company in one fund that no longer has capital to deploy may need additional equity to facilitate a strategic transaction such as an acquisition, and another fund that does have fresh capital may be in a position to back the deal; again, the same investment team may be best suited to evaluate the opportunity.
These are just a few examples of related-party issues that come up with some frequency, but for fund sponsors, the operative criteria for deciding whether to seek fairness opinions should be, is there potential for the perception to arise that the investors in one fund are disadvantaged relative to those in another fund?
Valuation approaches themselves do not change just because a fairness opinion assignment is associated with a related-party issue. For a straightforward enterprise value assessment of a portfolio company transferred to another fund, providers may employ a discounted cash flow analysis and/or assess value based on market comparables.
If a portfolio company is transferred and merged with a portfolio company of a newer-vintage fund and one group of LPs is invested in both funds while others are only invested in the newer-vintage fund, some math may be required to determine the new pro-rata ownership for the different LP groups.
Evaluating the fairness of contractual agreements between different companies held in different funds can be a challenge. In such cases, the fairness opinion provider may look at what it would cost the paying company to develop and provide the same services on its own (or what it has historically cost the company to do so) as well as the expected cost for the company receiving payment to provide the service, plus standard market profit margins for other companies providing similar services.
Apart from engaging in a messy court fight or writing “Dear Abby” to appeal for a ruling, families have few options for resolving disputes. Fortunately for sponsors of multiple private equity funds, fairness opinions represent a well-developed mechanism for evaluating and documenting potential issues between related parties before they become a problem.
More Perspectives: Fairness Opinions
Why Get a Fairness Opinion?
Allegations of mispricing a deal are one of the most common shareholder complaints – just such a case made fairness opinions commonplace. To the extent that arming oneself for potential litigation is an important reason to obtain a fairness opinion, it is worth understanding the “why” in getting one.
Overview of VRC Fairness Opinion Services
VRC has prepared fairness opinions for boards of directors, corporate legal advisors, private equity firms, institutional investors, fiduciaries, buyers and sellers, private company business owners, limited partners, and trustees.
Receiving Dependable Fairness Opinions
Boards of directors can improve the likelihood of receiving a more defendable fairness opinion by making specific inquiries of their opinion provider.
Conflict of Interest?
Fairness opinions provide substantial benefits – if the opinion process is performed correctly. Here, we focus on strategies for dealing with conflicts that may exist when a fairness opinion provider also receives an M&A success fee.