In the past five years, there has been a clear trend towards the use of continuation funds. They offer an exit route for some and the ability to remain invested in high-performing assets for others. They accounted for 50% of the US$126 billion secondary market volumes in 2021 and, as long as GPs want to hold assets rather than buy new ones, it is expected that their popularity will continue.

So, what are these funds, why are they used, what issues arise in their implementation and what can the parties do to make the often-complex process of forming a continuation fund run fairly and efficiently?

What is a continuation fund?

In its simplest form, a continuation fund transaction typically involves a sponsor setting up a new fund vehicle (the continuation fund) to purchase one or more assets from an existing fund, which is managed by the same sponsor.

In addition to capital commitments from new investors, investors in the existing fund are usually given the opportunity to "roll over" their interests into the continuation fund. There may also be a requirement to make additional commitments to fund follow-on capital as well as ongoing expenses.

Why are they used?

Closed-ended funds often have a life of between seven to 10 years. Difficulties typically arise at the end of the term – will a fund be a forced seller of its assets in a depressed market? While many funds do allow for extension periods, if there is no clear plan in place, their use (to investors) can seem like kicking the can down the road. 

For sponsors, the continuation fund option allows for continued management of strong assets that are not yet at full exit potential or which would otherwise benefit from a longer holding period than would be possible in the original fund. The GP can start again with a new strategy for the asset and attract fresh capital, whilst keeping close to investors who backed them from the outset and who want to "roll over" into the new fund.

For investors, continuation funds have provided an attractive liquidity solution in the context of ever-lengthening fund terms and ongoing market volatility. Those who want an exit can achieve one, whilst those who want to continue holding indirectly in an asset can do so, sometimes on better terms.

In theory, continuation funds represent a win-win-win for the sponsor, the exiting investor and the continuing investor.

What are the issues?

When setting up a consideration fund, there are complex tax and structuring concerns to consider. The position is made more difficult as it is unlikely that the possibility of a continuation fund will have been addressed in the partnership agreement of the existing fund. LPs, the most passive of investors, are placed in a position where they need to make decisions, often at short notice, about assets. 

The most fundamental issue is how to manage the sponsor's inherent conflict of interest in acting as both the "buyer" (continuation fund) and the "seller" (existing fund). Common examples of conflicts include how bids are made; does the GP get any economic incentives; what happens with carried interest.

There is plenty for investors, even those not on the LP Advisory Committee, to consider. 

These deals are complex and time-consuming from an investor's perspective. Managers need to take this into account and set appropriate response periods for their busy investors.

ILPA guidance – five takeaways

The Institutional Limited Partners Association (ILPA) has produced a guidance paper setting out matters for LPs and GPs undertaking a continuation fund process to consider. 

Five key takeaways from its guidance are:

Transparency always

The GP should be as transparent as possible throughout the process. The primary rationale for a continuation fund transaction should be to maximise the value for existing investors. Before formally moving forward with a continuation fund, the sponsor should share with the LP Advisory Committee and, in some cases, a broader subset of all LPs how this will be achieved. 

Managing conflicts

The potential for conflicts is many in the context of continuation funds e.g. how bids are made; does the GP get any economic incentives; what happens with carried interest. The review of conflicts associated with the transaction, undertaken by the LP Advisory Committee, should be aimed at ensuring that the process is transparent and fair to existing investors in the fund – the overriding goal of the transaction.

As part of an overarching drive to fairness and transparency for existing investors in the original fund, the GP should identify potential conflicts quickly, look at ways to mitigate them and refer them to the LP Advisory Committee for approval.

Any conflicts related to the process of the transaction should be identified, mitigated by the GP and approved by the LP Advisory Committee. This should be done as and when they arise, rather than "pre-cleared". 

LP Advisory Committee role

The LP Advisory Committee plays a crucial role in the approval process of a continuation fund. As mentioned, it will review conflicts. It also assists the GP in ensuring a fair and transparent process is followed. To help it do this, it should have access to independent advice, at the fund's expense. There should be full and clear disclosure of the proposed terms, with such information being given early in the timetable so that decisions are not rushed. The manner of the solicitation process should be clearly articulated so that the LP Advisory Committee members can determine the pricing is fair. Since LP Advisory Committee members act in their own interests and do not owe any fiduciary duties to the fund, they should be indemnified in relation to decisions they make.

Disclosures

So that LP Advisory Committee members can fully assess the proposal, as well as obtaining a fairness opinion from an independent source saying that the cash price offered for an asset is fair from a financial point of view, they should be given key information as early as possible, such as a description of the process soliciting bids and overview of bids received; management fee and carried interest percentages for investors in the continuation fund; and the reason for any crystallised carry being rolled into the new fund. In addition, all LPs (i.e. not just those on the LP Advisory Committee) should be provided with the information they need to review the continuation fund transaction, with no one LP getting more information than another. 

"Status quo" option and carried interest

LPs should be able to invest in the new fund with no change to the economic terms that apply to them in the current fund. This means no change to the management fee rate; no crystallisation of carried interest; and no change to the distribution waterfall that favours a GP. The default position should be that the GP rolls all its carried interest into the new continuation fund, demonstrating an alignment of interest.

Conclusion

It seems likely that continuation funds will remain an important feature of any "end of fund term" strategy, providing stability and certainty. Continuation funds have the potential to demonstrate the best elements of the funds sector. When used well, they are an innovative solution allowing a range of stakeholders to achieve different goals. The operational challenge for GPs is to structure and present to investors an investment choice that is fair, clear and unambiguous.