Secondary fund compliance and legal concerns

A secondary fund focuses on the private equity (PE) secondary market and directly or indirectly invests in existing PE investment funds or assets to earn investment returns.

Unlike traditional private funds, secondary funds acquire equity in portfolio companies or fund interests from PE fund investors, with fund investors as the direct or indirect counterparties. The core value of secondary funds is providing supplemental liquidity to the PE market.

Transactions by secondary funds, or secondary transactions, can be divided into two types based on investment methods: (1) direct acquisition of fund interests; and (2) establishment of a continuation fund to acquire the portfolio company’s equity held by a private fund.

Either way, the secondary fund acts as a fund investor. It should be noted that a continuation fund is not a secondary fund in the context of this article, but an investment vehicle used by a secondary fund for a secondary transaction.

Establishment and filing

In relation to private fund product and regulation, secondary funds are no different from traditional PE funds. However, they may face new compliance requirements following the revamp of regulations in 2023.

Under current filing rules, because a secondary fund is an investor of other funds, it must carry out filings as a PE fund of funds (FOF) or a venture capital (VC) FOF, whereas a continuation fund should file as a PE fund or a VC fund.

Although we do not expect the implementation of the Measures for the Supervision and Administration of Private Investment Funds (Draft for Comment) to alter the filing requirements for secondary funds, the upcoming regulation will have a great impact on fund sizes, the conditions of target investors and multi-layer investment restrictions of secondary funds. For example:

1. A secondary fund filing as an FOF must have capital contributions of at least RMB50 million (USD7 million), but with each investor being required to contribute no less than RMB1 million and the secondary fund being exempt from investment layer calculation. Therefore, except for the requirements for more capital contributions, a secondary fund filed as an FOF does not change substantially under the new regulation and enjoys the advantage of not being counted as an investment layer.
2. A continuation fund filing as a PE fund or VC fund must have capital contributions of at least RMB10 million, but each investor must contribute at least RMB3 million. Furthermore, such a continuation fund is subject to the multi-layer restrictions and, therefore, if the investors of such a fund include other PE funds that are not exempt from the investment layer calculation, the continuation fund can invest only in the equity of a private fund’s portfolio of companies, but not in other funds.
3. A continuation fund investing in the equity of a single project must have capital contributions of not less than RMB20 million, with each investor contributing at least RMB5 million. In addition, subsequent offerings may target only existing investors, thus excluding new investors.

Other legal issues

Legal due diligence. Fund interest transactions and transactions where continuation funds acquire interests in portfolio investments focus on different aspects in terms of legal due diligence.

Regarding the target fund, due diligence focuses on: compliance and involvement in litigation and disputes; basic information of the fund interests, capital commitments/capital contributions, whether there has been any default or the fund interests bears any liability (particularly adjustments of capital accounts after the secondary investment and the arrangement for participation in portfolio investments); whether the target fund’s other investors or general partner (GP) has a right of first refusal; whether the fund interests are encumbered by any pledge that could hamper the disposal; and the seller’s financial status, so as to determine whether there is any risk of the fund interests being frozen, enforced against or claimed by a third party before closing.

Regarding portfolio investments, due diligence focuses on: the business performance of the portfolio companies and the authenticity of operation data; whether the protection of shareholders’ rights in the original transaction documents conforms with the norm and if there are material omissions (e.g. absence of major investors’ rights such as a redemption right and/or a liquidation preference rights), and whether other relevant parties to the portfolio investments agree to the continuation fund’s succession to the various special rights granted to the target fund under the original portfolio investment transaction documents; whether the portfolio company’s shareholder agreement and articles of association restrict the continuation fund from directly or indirectly acquiring equity in the portfolio company; and information on the portfolio company’s business registration and ownership.

Related-party transactions and conflicts of interest. In a continuation fund transaction, these issues require special attention: fairness of the sale price of fund interests or portfolio; the GP team’s time allocation between the continuation fund and other funds; and how the continuation fund can obtain fair treatment in the timing, terms and conditions of a future divestment.

Cross-border transaction compliance. If the acquisition of fund interests or equity in portfolio investments by a continuation fund involves cross-border transactions, it should be considered whether overseas direct investment approval/filing is required, or if a QFLP pilot structure is necessary for the transaction.

State-owned asset transaction compliance. Particular rules apply here. For example, the transfer of the target fund interests by a state-owned entity may require asset appraisal or have to be done publicly in the equity trading market.

With steady progress in the private fund market, secondary funds will enjoy a more professional and efficient environment, permitting them to better fulfil their role of providing supplemental liquidity for the primary market of private equity. With the joint efforts of private fund managers, investors and professional secondary investment firms, secondary transactions of private funds are expected to inject new vitality into the private fund market.

Ran Lu is a partner at Han Kun Law Offices. She can be contacted by phone at +86 10 8525 5521 and by email at lu.ran@hankunlaw.com

Pei Zhihao is an associate at Han Kun Law Offices.
He can be contacted by phone at +86 10 8516 4263 and by email at zhihao.pei@hankunlaw.com