Inter‑fund sales, the Sartor and Continuation Fund case (I)

Funds or LPA of alternative assets

As we know, alternative asset funds are becoming increasingly important every day. They consist of holding assets, from companies to debt, that are not traded on public markets. One of their most relevant characteristics is the term that the fund itself or the asset holding usually has. It begins with the commitment period, during which investors’ (LPs’) money is invested. Then comes the period in which exiting the fund is restricted, generally while improving the purchased asset with a discount and leverage. Finally, there is the liquidation.

Liquidation consists, simply, of creating a liquidity event, e.g., selling that asset or, in the case of private equity, an IPO. That allows the fund to distribute the proceeds to investors.

The time limit of the investment matters, of course, for the investor’s liquidity, but it is also the main incentive to prevent opportunistic behavior. The manager (GP) has absolute control over the investment, without the intervention of the basic and general governance principles of capital companies or funds with contributors’ meetings, except for extremely significant decisions, such as dissolution due to the GP’s bankruptcy. This total power over the asset is precisely limited by time.

Time forces the manager to raise capital frequently and, for that reason, exposes them to putting their reputation at stake. As we know, this combination leaves them at the mercy of market discipline. This time limit also incentivizes moderating the asset valuation, which is controlled by the GP.

Now, within the configuration of this business, conflicts of interest abound, as in all finance. But here is the important point. In these businesses, waivers of fiduciary duties are often significant. This, together with the structural weakening of LPs’ rights—where they lack important legal tools to challenge GPs’ decisions—ends up increasing the risk of conflicts. This landscape has formed because these structures usually include institutional investors who, in theory, can better deploy freedom of contract to negotiate effectively.

On the other hand, it is the time limit that usually unleashes the greatest conflicts of interest. Because the terms are set from the start, the liquidity event is often expected to be accompanied by pressure on the GP.

Inter‑fund transactions. Importance

The liquidity event seeks to enter a secondary market with the respective asset. There are several ways to achieve this. We already mentioned the IPO. In the case of a sale, there are various formulas.

Classically, the secondary market for alternative assets consisted of transactions in which the rights and obligations of the LP in an LPA or fund are transferred, that is, an assignment of the contract. As we know, in a contract assignment the buyer assumes the contract’s entire legal position, including, in this case, the contribution to capital calls.

But now there are several options, many of which include the possibility of transferring assets between funds managed by the same GP.

There are, of course, secondary funds that specialize in price discovery for alternative asset funds by buying their assets. Similarly, there are processes in which the GP itself offers the current LP’s asset to a third party, creating windows of opportunity to participate in these liquidity events.

Another formula is the strip, that is, the partial sale of the fund’s assets, seeking to realize the increase in the asset’s value without losing the opportunity to benefit from the appreciation of the remaining assets. Here the GP selects the asset.

Stapled primaries are one of the mechanisms that can give rise to conflicts of interest. This transaction is a hybrid: the GP sells part of the assets or offers a window for the current LPs to assign their contract so that another buyer (a new LP in the existing fund) can enter; simultaneously, that same buyer commits primary capital to invest in a new fund managed by the same GP.

And the one we will develop in the following installments, which we believe is the best option, is the continuation fund. It involves transferring assets from an existing fund to another fund managed by the same GP. For it to work properly — not as in the Sartor case, as we will see — the LPs of the existing fund are given the option to withdraw their money or to acquire a stake in the new fund. The purchase of the interests of LPs who choose to withdraw is financed with the proceeds of the new fund’s transaction.

These last two operations strain the GP’s fiduciary duties in the original fund to maximize LPs’ interests, and the GP’s duties in the fund that acquires or disposes of the asset or in the new fund.

Case

The so‑called Sartor case, which occurred in the Chilean jurisdiction, has attracted a great deal of attention for several reasons. In general, when we review the sanction by the Chilean regulator (the Commission for the Financial Market, CMF) against the fund management company Sartor (Sartor AGF), it is clear that related‑party transactions took place, including, directly or indirectly, transactions between funds (public and private).

The challenged transactions involved loans or transfers of assets carried out by the affected funds to companies related to Sartor AGF, to other of its funds, and to its directors or managers. There were also poorly managed funds that invested in other Sartor AGF funds (public and private), including reciprocal investments among funds managed by Sartor AGF or its related parties.

We will set aside all the breaches except one, which is the one on which we will focus. This concerns the transaction between the private investment fund Sartor Lonco, managed by Sartor Administradora de Fondos de Inversión Privada (Sartor AFIP), on the one hand, and the investment fund Sartor Proyección, managed by Sartor AGF, on the other.

The asset transferred consisted of a promissory note, a commercial instrument, representing the documentation or recording of a debt whose debtor was Inmobiliaria Altos de Lonco SpA (a real estate developer). By means of an act of transfer of ownership of the asset called an endorsement — a form of transferring title in Chile regulated under commercial law — the private investment fund transferred the asset to the Sartor AGF investment fund.

Although, as we will see, the above transaction is absolutely prohibited under Chilean law (unlike in some other jurisdictions), it allegedly failed to properly address conflicts of interest. And, as mentioned, we are dealing with a transaction similar to what we have called a continuation fund.

Violation

The violation identified by the regulator is the prohibition set forth in Article 22, letter g) of Chile’s Single Funds Law (Ley Única de Fondos, LUF). This is a prohibition: there is no exception permitting what the law forbids.

For our purposes, it is contrary to Chilean law for the fund manager, or persons participating in its management (making investment decisions), to carry out acts or omissions directed at the acquisition or disposal of assets on behalf of the fund in which the manager acts for itself as seller or buyer, or in which a private fund under its management or a company related to the manager acts as seller or buyer.

The scenarios described by the law therefore comprise several distinct prohibitions.

It prohibits actions or omissions by the fund manager aimed at acquiring an interest for itself where the counterparty is the fund that the law seeks to protect.

It prohibits actions or omissions by a private fund under the same manager aimed at acquiring an interest for itself where the counterparty is the fund that the law seeks to protect.

It prohibits actions or omissions by a company related to the manager aimed at acquiring an interest for itself where the counterparty is the fund that the law seeks to protect.

It prohibits actions or omissions by the fund manager aimed at disposing of an interest where the counterparty is the fund and the manager acts for itself, and which the law seeks to protect.

It prohibits actions or omissions by a private fund under the same manager aimed at disposing of an interest where the counterparty is the fund and the private fund acts for itself, and which the law seeks to protect.

It prohibits actions or omissions by a company related to the manager aimed at disposing of an interest where the counterparty is the fund and the related company acts for itself, and which the law seeks to protect.

In a subsequent installment we will examine the interpretation of this rule. The important point for now is that this prohibition admits no exceptions, unless the requirements set out in the rule are not met. The legislator’s suspicion of inter‑fund transactions is apparent.