For private equity and other closed-end funds launched during the boom years of 2016-2022, maximizing the value of their remaining assets has become urgent. The ubiquity of capital and high asset prices during that period set a high bar for achieving significant returns. Managers are now grappling with the prospect of somewhat subdued valuations and a constrained deal-making environment.
In seeking ways to maximize their returns and satisfy their near-term liquidity obligations, managers have identified a new buyer for their portfolio companies: themselves. The concept of continuation funds has emerged as a strategic solution to these valuation and liquidity challenges, enabling managers to navigate market conditions while retaining control over the timing of their exit from remaining investments.
What is a Continuation Fund?
Continuation funds are used in connection with general partner (GP) led secondary transactions.
In a traditional secondary transaction, a limited partner (LP) typically initiates the process by approaching buyers and then transferring their interests to a buyer with the GP’s consent. The buyer assumes the role of the LP and undertakes the seller LP’s obligations to the fund, including the obligation to satisfy any remaining unfunded commitments.
In a GP-led secondary transaction, however, the GP offers existing LPs the choice to sell all or part of their fund interests to a buyer during a designated period. When a GP-led secondary involves a continuation fund, the existing fund sells one or more portfolio companies to a newly established continuation fund, managed by the same sponsor. The continuation fund is explicitly created to acquire the portfolio companies.
Investors in the transferring fund have an option, either to take a distribution of the proceeds from the sale of the portfolio company as part of a liquidation of the transferring fund, or, to roll over their interest by taking an equity stake in the newly-established continuation fund at the value of their interest in the transferred assets at the time of the roll-over.
Typically, the continuation fund also raises capital from new investors in order to pay the purchase price for the portfolio companies to the transferring and such proceeds are used by the transferring fund to pay withdrawing investors. Additional capital commitments to the continuation fund may also be raised in order for the continuation fund to make for follow-on investments in the portfolio companies.
Advantages to Continuation Funds
Existing Limited Partners: Existing LPs may find continuation funds attractive for various reasons. Primarily, they prolong the period in which an LP can remain invested in portfolio companies that the manager believes have significant upside value. If market conditions are depressed, managers can defer selling the asset until market conditions improve. By rolling over into a continuation fund, existing LPs can capitalize on this additional value creation or improved market conditions, which may result in enhanced returns.
For LPs that need or desire liquidity, the launch of a continuation fund makes that possible within the time frame for which they contracted when they made their initial investment in the liquidating fund.
General Partners: GPs gain enhanced flexibility to extend holdings in specific investments, liberated from the existing fund's term constraints. This flexibility allows GPs to exert greater control over the timing of exits. By transferring assets into a continuation fund, GPs can strategically manage the divestment process in line with market conditions and expected underlying asset performance trajectories, potentially increasing their returns.
New Limited Partners: New LPs in the continuation fund are keen participants in these transactions because they can often gain access to a private investment at an attractive valuation. Also, the term of continuation funds is generally materially shorter than traditional PE funds, typically three to five years. This shorter investment horizon boosts the IRR the new LPs realize on their capital and frees that capital for reinvestment more quickly than would typically be the case.
Navigating Challenges
The dual role assumed by managers, straddling both the sell-side and the buy-side, prompts scrutiny over asset pricing and managerial motivations in transferring assets to a related vehicle. The economic terms negotiated by managers with investors in the new vehicle, often involving heightened carry and sustained fee income, add layers of complexity. Moreover, GPs must balance the conflicting interests of two investor groups: the existing LPs seeking to sell the fund's assets at the highest possible price, and the new LPs investing in the continuation fund, aiming for the lowest purchase price. As a fiduciary to both the legacy fund and the continuation fund, the GP is obligated to act in the best interests of each group of LPs while navigating through a complex web of conflicts.
This dynamic has drawn the attention of regulators.
Under the new Private Fund Adviser (“PFA”) rule adopted by the Securities and Exchange Commission (“SEC”), advisers must, prior to the deadline for investors to elect whether to participate in a continuation fund, (i) obtain and distribute to investors a fairness opinion or a valuation opinion from an independent opinion provider; and (ii) prepare and distribute to investors a written summary of any material business relationships that the adviser or any of its related persons have or have had with the independent opinion provider within the two-year period preceding the issuance of the applicable opinion.
Advisers with $1.5 billion or more in private funds assets under management have until September 24, 2025 to comply with these rules. Advisers with less than $1.5 billion in private funds assets under management have an 18-month transition period for these rules, giving them until March 24, 2025.
Conclusion
Continuation funds provide a strategic solution for maximizing value and will undoubtedly continue to be used by GPs and their investors to realize higher returns. Through transparent governance and regulatory compliance, stakeholders can find alignment, ensuring equitable outcomes and fostering trust.
