Continuation funds can be a useful tool for GPs hoping to reincentivise deal teams. However, alignment within the GP itself is critical to getting a deal over the line.
A continuation vehicle for a GP can reset carried interest, which in turn allows parties to realign those individuals who will take the asset forward. For the GP, this presents another opportunity to manage team dynamics, according to market participants.
“It offers the opportunity to look at who’s doing the work, who they’d like to reward,” says Andrew Rearick, international counsel at law firm Debevoise & Plimpton.
Mark McDonald, managing partner of the private equity business at asset manager DWS, agrees, saying continuation funds “are another economic tool that the GP can use to increase alignment for more junior talent and expand incentives for new partners”.
In some senses, this places GPs in the LPs’ position: using continuation funds, firms can offer existing carry holders that no longer have any influence on the companies involved (departed partners, for example) the opportunity to roll or cash out. “But it doesn’t affect the new carry for the team,” says Immanuel Rubin, head of European secondaries at Campbell Lutyens, adding that this is one of the “beauties of these transactions”.
It’s not just within the GP’s interest to realign parties. If you want to get a deal done smoothly, you need to create as little friction as possible in the terms package. “[This] means very strong alignment; the right people are getting the economics,” says Dushy Sivanithy, managing director and head of secondaries at CPP Investments, adding that the investor has seen some recent trades where the beneficiaries of the new vehicle look quite different to the beneficiaries of the selling vehicle. “That’s because there’s been
Don’t forget the day job
The economic incentive is not the only important consideration for GPs entering into a continuation fund: alignment is achieved just as readily, if not more so, through reputational alignment, says John Rife, a partner at Debevoise & Plimpton.
“What a sponsor doesn’t want to do is find that they… ran roughshod over their LPs in connection with these kinds of continuation vehicle transactions,” Rife says. “[They don’t want to end up] compromising their reputation, their ability to go out to do what their real day job is – which isn’t doing these continuation fund transactions, it’s raising new blind-pool capital.”
Sivanithy adds that individuals at GPs tend to stick around for the duration of the life of a continuation fund because they are “very attractive transactions” that often enjoy “a reasonable level of success”.
As a consequence of the growing popularity of continuation funds, Sivanithy anticipates that GPs may be asked to disclose the performance of their GP-led vehicles moving forward. “Ultimately, it is AUM they control, [which] should be monitored from a performance perspective and, frankly, from an economics generation [perspective], because some of these can meaningfully change the economic alignment – particularly if too much is in some of the [deals] that the funds do not get sufficient attention.”
Typically, a continuation fund’s carry is structured in tiers. If certain return hurdles are met, managers will get more of the profits, incentivising the team to focus on performance.
Some secondaries investors are trying to bind GPs into contractually agreeing to vesting schedules within continuation funds. “What that means is senior people, junior people, everybody will be entitled to some portion of the carried interest generated by this continuation vehicle over its life,” John Rife, a partner at Debevoise & Plimpton, tells PEI.
Such a structure has multiple effects for alignment: although the money rolled into a continuation fund at the outset may be fronted up by more senior members of the fund, a vesting schedule incentivises all carried interest recipients to stick around for the life of the continuation fund. If someone who committed to the continuation fund at the outset leaves, for example, they will not forfeit the gains realised on their investment interest in that asset – instead, they will forfeit their share of carried interest proceeds after departure. This is then reallocated to those who remain.
“What you need to do is to make sure… there’s no reason for the senior person to leave and still feel like they’re not leaving substantial money on the table,” Rife says.
– This report appears in the September Secondaries Special of affiliate title Private Equity International.