Continuation funds have rocketed into the spotlight as more and more private equity funds look to hold assets for longer than their original fund terms allow. The vehicles allow sponsors not just to continue to manage problematic assets until they reach a desired performance, but to capture further upside on good performers.
Because of the conflicts of interest that arise from managing both an existing investment vehicle and another vehicle into which the first’s asset or assets are sold, sponsors need to think about how to strike the right balance of profit and fiduciary duty.
Continuation funds: The numbers
Over the past year and a half, GP-led secondaries have surged to make up around half the deal volume in secondaries transactions.
According to Hamilton Lane, from the 12 months before July 2021 the average continuation fund deal size was $1.1 billion, and single-asset deals made up nearly half of all continuation vehicle transactions.
The secondaries market in general has been hot, with a record number of deals in 2020. Capital raised in secondaries shot up 110 percent in 2020, with more than $89 billion raised across 57 funds. While there was a decline in activity in 2021, secondary fundraising still outpaced 2017, the previous record-setting year.
Pitchbook analysts noted that the high rate was no surprise, since many secondaries managers were still absorbing capital raised in 2020. They added that GP-led transactions, which include continuation funds, have grown at a 52 percent compounded annual growth rate since 2016.
And because GPs view the secondaries market as a more attractive alternative to traditional investment exit options, GP-led secondaries and continuation funds are expected to become an even greater percentage of overall fund market liquidity in the coming years.
Andrew Gulotta, partner with Sixpoint Partners and a member of its secondaries advisory business, has seen multiple continuation fund launches recently, with an emphasis on single-asset funds.
“In most of the deals
we’re working on, a
sponsor is cherry-picking
[an asset] and… keeping the
asset because they don’t
want to give up the
business yet”
Andrew Gulotta
Sixpoint Partners
“In most of the deals we’re working on, a sponsor is cherry-picking either a single asset, or two or three assets, that are nearing the end of the investment period and, instead of selling the assets, keeping the assets because they don’t want to give up the business yet,” Gulotta explains.
Brad Young, global deputy CIO of private equity at Mercer, agrees that continuation funds continue to accelerate in popularity. “I think one of the benefits of these structures is that it gives managers more time to manage a very strong performing asset or to dedicate a little more time and resources to an asset that still has significant upside potential,” he says.
“Continuation funds also give a lot of LPs the liquidity they want, while allowing other LPs to roll over and continue forward in the new vehicle that has a stronger alignment of interest with the GP.”
According to Yasho Lahiri, a partner in the asset management and investment fund practice of K&L Gates, disclosure and communication are key to successfully navigating the conflicts of interest that arise in transactions between two funds managed by the same firm, but with potentially different investors.
“When you have a conflict of interest and fiduciary duty concerns like we see with continuation funds, then you need real, informed consent,” he says. “You need to disclose all material facts and material conflicts of interest. And, you need to give people enough time to think through the conflict and think through issues before making an investment decision.”
When a GP begins considering a continuation fund, the first step is to review the operating documents of the fund holding the asset or assets to be sold. Also, many funds’ LPAs require GPs to get advice from outside counsel on, and give LPs or LPACs right of consent to, conflicts of interest and any other issues may come up.
At Debevoise & Plimpton, partner Andrew Ahern advises GPs to think about what is in the best interest of investors – both those in the original fund and those that will be in the continuation vehicle.
“Each transaction presents its own circumstances and there is no one right way to handle conflicts of interest. What is most important for a sponsor to do is to explain the conflicts that are present and how you have dealt with them so that your investors can make an informed decision,” Ahern says.
Young notes that the rational for moving the asset to a continuation fund is important in making sure one group of investors is not being unfairly advantaged over another.
(Fiduciary) duty-bound
Under the Investment Advisers Act of 1940, the GP owes fiduciary duties to each of the funds that it advises. That presents an obvious complication: in forming a continuation fund, a GP serves in a fiduciary capacity to both the initial fund that is selling the asset and to the continuation fund purchasing it.
“If you’re setting up another fund, you have to satisfy your duties to that new fund,” says Ahern. “This includes setting out rules for how the funds will be managed going forward, negotiating the economic provisions and considering alignment between the sponsor and the investors, and anticipating potential future events such as the need for more capital in the company. As part of the transaction process, these key terms will also be disclosed to the investors in the original vehicle as they consider whether to consent to the transaction and participate in the new vehicle.”
Throughout the process of launching the continuation fund, GPs should focus on ensuring there is full and fair disclosure of all material information, including conflicts of interest to the LPs about the new vehicle, K&L Gates’ Lahiri adds.
Whose price is it anyway?
The price at which the initial fund sells the asset to the continuation fund is a primary concern for both the sponsor and investors. The assets being transferred are, of course, level 3 assets that need to be marked at fair value, rather than at a market price determined during a sale.
Should a continuation later sell its assets at a significantly higher price than that at which it was fair valued as it exited the previous fund, the investors of the initial fund might suspect they were misled into selling at a discount.
Conversely, if the initial fund sells the asset at a higher valuation than it is sold for later out of the continuation fund, it could indicate LPs of the continuation fund were disadvantaged in favour of the original investors.
The balancing act for GPs, Lahiri explains, is to set a price for the asset so that investors who are getting liquidity and cashing out of the initial fund feel they are getting a fair deal, and so that prospective new investors or other sponsors coming into the continuation fund are not put off by that price.
But even bringing in a third party to conduct a valuation of assets before they are sold to a continuation fund can present conflicts of interest, says Ahern, since the ‘sellers’ – the investors in the original fund – are the ones paying the third party.
“Interests are better
aligned when the
GP itself rolls over a
substantial stake at the
same price as the new
and old LPs”
Andrew Ahern
Debevoise & Plimpton
“We believe a better arrangement is for the price to be set by another GP or professional investor entering the fund – the price it comes in at then sets the price for other investors entering or exiting. In addition, interests are better aligned when the GP itself rolls over a substantial stake at the same price as the new and old LPs,” he says.
In Ahern’s view, another significant economic issue that generally arises when launching a continuation fund is the sponsor’s economics, particularly the fees the sponsor receives over the course of executing a sale to a continuation fund.
“I would say that the best practice for mitigating the conflicts here really depends on the portfolio company and the circumstances surrounding it,” Ahern explains. “For the price, a common approach is to run an auction with secondary buyers and selecting buyers based on the prices submitted. In some circumstances the presence of a third party can help with price verification. As an additional mitigant, you can obtain a fairness opinion, which we’ve seen in a number of these deals.”
To reduce the potential conflicts of interest arising from the GP determining a value on which it will receive carried interest, Ahern says GPs may elect to take their carried interest partly in cash and partly through an interest in the continuation fund.
“Transparency and communication are key with these transactions, especially with the issue of
conflicts. Deals that lack these elements are
often challenged”
Tom Kerr
Hamilton Lane
According to Tom Kerr, managing director and the global head of secondaries at Hamilton Lane, a fairness opinion may be best because valuation issues can be hard to resolve when the manager thinks an asset is worth one price but the market prices it at something else.
“In that situation, if the manager doesn’t agree with the market price for an asset, it’s best to disclose why the manager disagrees and why she or he feels it is worth something else. In that case, I would say it’s a best practice to get a fairness opinion.”
Regardless of the method used to value an asset, Andrew Gershon, counsel at Debevoise & Plimpton, says communication with investors is key.
“I think the main questions for the investors are: what is the price of an asset? Who was involved in the valuation? And how big was the potential universe of buyers? You really need to make sure investors understand your process for valuing the asset and have an opportunity to ask questions or raise concerns.”
“You need to
communicate what
issue the transaction
is addressing and why
a continuation fund is
the best approach”
Andrew Gershon
Debevoise & Plimpton
Continuing communication
On the point of communication, GPs need to make full and fair disclosure of all material information to the LPs in connection with the continuation fund.
While investors do not make investment decisions for a fund, it can be helpful to involve them throughout the process and provide them with an opportunity to raise concerns and ask questions along the way.
As Kerr explains, “transparency and communication are key with these transactions, especially with the issue of conflicts. Deals that lack these elements are often challenged. So, I would say that throughout the process, it is imperative to be transparent with investors about what you’re doing.”
Sponsors set up a data room with information on the fund’s investments to ensure investors have all the information needed to decide whether to cash out of the initial fund or roll over to the continuation fund, says Thiha Tun, a partner at Dechert.
“As the process of finding secondary buyers moves along, the manager should keep key investors updated on the whole process; who has participated and what prices were offered. It will then decide on the winning buyer and negotiate a term sheet. A final presentation is made to the LPAC and a vote taken on whether the conflicts should be waived so that the transaction can proceed.”
Sixpoint’s Gulotta notes the data rooms will include fundraising data and company or portfolio data. “Investors need to be able to look at the assets and the investment thesis,” he says.
“LPs in the initial fund and potential investors in the continuation fund want to know what the manager has done with the business so far, where the business is in its life cycle with value creation, how much upside remains, and what the go-forward equity potential is under the continued ownership of that manager.”
Lahiri says that since the sponsor has most likely been thinking about launching the continuation fund for some time, there is a lot of information to share with the LPs. “Using the example that you have one operating business that you want to put into a continuation fund, you start with the knowledge that the LPs likely have a lot of information already about the business from investor letters over the years.
“What they don’t have is specifics about the future prospects for the business, which is really important. LPs also need to understand what the risks are in that business and what the business needs in order to succeed, whether it’s capital or it has a particular challenge. That disclosure is pretty important.”
Gershon adds: “I think investors are a little more familiar with the transaction type and the process, so they are more adept at reading the documents and are better able to assess the opportunity. But, with these transactions, the context is very important, and you need to communicate what issue the transaction is addressing and why a continuation fund is the best approach.”
Mercer’s Young agrees that making the case for a continuation fund as the best approach for investors is paramount. “Explain to them the pricing; how it’s being done, and who’s doing the pricing. You also want to let investors know about the economies associated with the deal, particularly what the sponsor stands to gain.
“Because that will play into the fiduciary duty question, and whether the sponsor is doing the continuation fund for the right reason, and not because it’s the most favourable financial option for him.”
Dechert’s Tun says because these transactions are fraught with potential conflicts of interest, they require detailed disclosures about conflicts and how they are being mitigated, and consent from investors is normally needed.
“This is where you see limited partner advisory committees getting involved,” Tun says.
“One of the functions of a limited partners advisory committee is to consider and, if thought fit, to waive conflicts of interest.”
But best practice is always to get LPs’ or the LPAC’s consent, even if the fund documents do not require it, adds Gulotta.
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