Investors push for greater alignment in continuation vehicles versus blind-pool funds

Funds set up to allow sponsors to hold assets for longer typically must satisfy both an IRR and MOIC hurdle, research from law firm Paul Hastings has found.

Investors who back continuation funds are seeking more specific return thresholds than those associated with traditional blind-pool vehicles, research from a law firm has found.

Just under half of continuation funds in a study by Paul Hastings, shared exclusively with Private Equity International and Secondaries Investor, set their carried interest waterfalls as determined by both internal rate of return and money multiple.

Blind-pool funds typically set their preferred return – the hurdle rate which the fund must hit for the manager of the fund to begin receiving carried interest – solely by IRR, with 8 percent being the industry standard.

“If you hardwire in a minimum money multiple, it’s saying that in order for us [the GP] to share the profit, we don’t just have to give you a decent IRR, we also have to return you a certain amount of cash,” Ted Craig, a partner in the firm’s private investment funds practice, told SI. “It means you can’t hit the [preferred] return just by having a quick exit, selling the asset above the required IRR.”

Three-quarters of continuation funds’ waterfalls had ratchetted carry mechanics, according to the research. For example, a typical continuation fund may set a 10 percent hurdle with a 1.5x net multiple on invested capital for 10 percent carry, a 15 percent hurdle with a 1.75x net MOIC for 15 percent carry and a 20 percent hurdle and 2x net MOIC for 20 percent carry, the research found.

Critics of continuation fund processes point out that alignment between the GP and its investors – existing LPs who choose to roll over their exposure into the new vehicle, and secondaries buyers – is key to addressing potential conflicts of interest.

Paul Hastings’ data also found that the most common GP commitment to a continuation fund was 5 percent of the size of the vehicle. The next most common commitment size was 10 percent.

When it comes to management fees, just over one in four continuation funds did not charge these at the continuation fund level, instead charging either ongoing monitoring fees or a one-off transaction fee at the portfolio company level. The bulk of continuation funds (43 percent) charged a 1 percent management fee – below the industry standard 2 percent fee for primary blind-pool funds.

Investors evaluating the cost of investing in a continuation fund should look at the total fees being charged – at both continuation fund and portfolio company level – and not simply whether a fund does or does not charge a management fee, Craig noted.

“From an investor’s perspective, [they should] check where the fees are being charged, whether they’re offset against each other, and if they’re not, what the aggregate fee is,” he said. A continuation fund sponsor that charges no management fee at the continuation fund level may instead charge an ongoing monitoring fee of equivalent quantum. As this is charged to the portfolio company, the capital would not need to be directly funded by investors at the outset, he added.

Paul Hastings’ data set comprised continuation funds between the fourth quarter of last year and first quarter of this year, ranging from $250 million to $1.3 billion in size, with portfolio company sectors spanning healthcare to media. More than two-thirds of the continuation funds involved sole assets.

The continuation fund market was worth around $52 billion last year, according to investment bank Lazard’s Sponsor-led Secondary Market Report 2021.