For many sponsors, a fund approaching the end of its life while still having substantial unrealised value in a series of assets creates an issue. Although private equity funds have long lives, generally 10-year+ closed-end structures, even that is sometimes not sufficient to realise the assets. This is where a continuation fund comes into play, offering a solution for both sponsors and LPs, which avoids an extension or worse, an ill-timed sale.
What are continuation funds?
Continuation funds are a liquidity solution offered generally by secondary managers which falls under the category of GP-led restructuring. According to Evercore, this type of transaction has grown in size from representing less than 5% of the secondary market volume in 2013 to representing almost 50% in 2020. The pandemic has accelerated the trend of continuation funds as assets have needed longer to mature.
Broadly speaking, a continuation fund is a fund that offers a liquidity solution for the sponsor for those longer dated assets. One or more assets of a fund in existence is acquired by a new vehicle managed by the same sponsor (the continuation fund). LPs in the existing fund can either roll over into the continuation fund or sell. New investors can also come into the new continuation fund, thereby providing additional liquidity for those exiting.
While continuation funds were originally used by GPs running into problems, they are now a mainstream management tool to provide liquidity for investors and to extend the time a GP can maximise the value of one or several underlying assets. Continuation funds can be put in place for one asset, a portfolio of assets or even one or more parts of different assets.
Are continuation funds complex?
Continuation funds can be complex to put in place. Taxes, legal documentation, allocation of expenses (i.e. the cost of the transaction) and conflicts of interest are just a few issues to address. On the tax side, the existing fund tax structure might be adapted to suit the exiting LPs but may not be as suitable for a secondary fund which has a different tax regimen. The legal side of any GP-led restructuring has to be carefully considered, because GPs are inherently fiduciaries to their investors and subject to various laws and duties.
The potential for conflicts of interest is one of the trickiest issues for a continuation fund: what is the rationale for the GP/sponsor to want to hold on to some assets when they could simply exit as their fund comes to the end of its life? What price will the assets be sold at? Simply put, the sponsor is on both sides of the transaction as it is the manager of both funds, new and old, and will have to manage the differing interests of exiting and continuing LPs, as well as new investors.
A sponsor may manipulate a deal deliberately to undervalue its original fund NAVs in order to convince LPs to do a deal (some managers have been sanctioned by the SEC for such manipulation); or they may include assets which have little prospect of additional value to earn more fees; or fail to provide adequate disclosure. A continuation fund may come also with a “stapled” commitment from the new LP to a separate fund of the sponsor (which in turn helps the sponsor raise money for a new fund), which also can create significant conflict on pricing in certain situations.
For example, in a GP-led transaction, the sponsor might choose to pick the lowest bid on the assets just because there was an offer of a stapled commitment with it. The situation is then detrimental to the LPs who are not being offered the best price. Because the sponsor’s reputation is at stake, market participants in general choose to either disclose the conflict of interest, seek a fairness opinion the price is adequate or seek an external advisor. The world of private equity is dominated by the strong relationship between GPs and LPs, and the credibility and trustworthiness of GPs are key.
What are the terms for LPs?
One of the interesting aspects of continuation funds is that terms for the original fund can be different from those of the new funds, with LPs the beneficiaries of this change. LPs also gain the flexibility to reduce, roll over or increase their allocation. The new funds can therefore have better terms with an incentive better aligned than it was when the fund was originally set up possibly 10 years ago. Teams might have changed as well over such a long period of time and it might make sense for everyone to cash out the old partners and allocate carry to the new team, again aligning interests better.
GP-led secondaries are here to stay and are becoming more used across other assets as well as private equity, such as credit and infrastructure). There are many other types of fund restructurings that can be seen in the market, such as tender offers, strip sale, preferred equity or NAV financing to name a few. If you are looking for liquidity for your funds and want to discuss potential solutions or just more information, please reach out to us.