This month the Institutional Limited Partners Association published its guidance on continuation funds, and it’s hard to argue that a best practices guide for the fastest growing sub-sector in private markets isn’t a good thing for investors.
The guidance, Continuation funds: Considerations for Limited Partners and General Partners, is ambitious and largely walks a deft line between offering practical guidance for LPs while attempting to not be overly prescriptive. At 14-pages it is longer than the industry body’s guidance on subscription credit lines and even outpaces its initial 2019 guidance on GP-led fund restructurings.
This latest guidance tackles the biggest gripes LPs face when dealing with continuation fund processes: unreasonable timelines by which to decide whether to roll or sell; whether pricing is fair and market tested; and how to think about what GPs should do with any carried interest generated from the process. It provides specific advice on what to ask GPs, on process and timing of such transactions, and terms and documentation.
Legal sources we spoke with agreed that the majority of ILPA’s latest guidance will equip LPs with the tools they need to process continuation fund transactions in their best interest – though some were quick to point out that many of the points in the guidance are already standard market practice.
Underpinning the guidance are two fundamental principles: that continuation fund processes should maximise value for existing LPs; and that LPs who choose to roll over their exposure should be no worse off than if the process hadn’t occurred – in other words, having a true status quo option.
“LPs must be provided the option to participate in the new structure with no change in economic terms i.e., a ‘status quo’ option,” ILPA notes in its guidance. By ‘status quo’, ILPA says this means there should be no increase in the management fee rate; no change in the management fee base; no increase to the carried interest rate, decrease to the hurdle rate or other GP-favourable changes to the distribution waterfall; and that there should be no crystalisation of carry for rolling LPs.
It’s this second point about status quo options that legal experts point out will be tricky to implement.
“Whilst ultimately these are commercial rather than legal matters, these points can be quite difficult to prescribe in the abstract,” Clifford Chance wrote in a note about the guidance this week. ILPA’s guidance around carry crystalisation may pose incentivisation challenges for managers of longer term products, and it also does not distinguish between transactions that happen early in a fund’s life versus at the end of a fixed term, the law firm wrote. As such, continuation fund processes should be considered on a case-by-base basis, it added.
Further, if there is no carry crystalisation for rolling LPs, this could encourage a situation in which GPs prefer as many LPs as possible sell their exposure, to minimise the number of LPs who roll, Clifford Chance noted.
Also at question is whether ILPA’s guidance treats continuation fund processes as an exit for a particular asset or assets. With IPO markets shut and sales to private equity buyers challenged due to the higher cost of leverage, selling an asset into a continuation fund and providing distributions to LPs that want them, while simultaneously giving LPs the option to re-invest in that asset, can be as true an exit as any, says Gabriel Boghossian, partner at law firm Stephenson Harwood. He adds that ILPA’s guidance on status quo options does not suit all scenarios.
“If it’s a true exit, and you’ve produced an exit that you promised, I don’t necessarily feel that you are duty-bound to offer a historic management fee base [to rolling LPs],” Boghossian says.
A true status quo with no change to fund economics for an LP is impossible to create in a continuation fund process, as we explore in the latest episode of our Second Thoughts podcast. In our view, this bone of contention will require more of the industry’s attention as continuation funds become ingrained as a fourth exit route for private markets GPs.
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