Sonia Bhasin, General Counsel
Sonia discusses the use of continuation funds as a solution for private equity funds that are nearing or past their expiration date and have unrealized assets in their portfolio.
Private equity funds typically have a fixed life span of 10 to 12 years, after which they are expected to liquidate their portfolio companies and return capital to their investors. However, in recent years, many private equity funds have faced difficulties in exiting their investments due to factors such as market volatility, sanctions and regulatory uncertainty, and operational challenges.
As a result, some funds have reached the end of their contractual term without being able to fully realize their assets and generate returns for their investors. One solution that has gained popularity among private equity managers and investors is the use of continuation funds.
What Is a Continuation Fund?
A continuation fund, also known in some circles as a general partner led secondary fund, is a new fund that is set up to acquire some or all of the remaining assets of an existing fund and continue to manage them for a longer period. The existing fund’s investors are given the option to either sell their interests in the assets to the continuation fund, or rollover their interests and remain invested in the assets by participating in the continuation fund. The continuation fund may also raise additional capital from new investors to finance the acquisition and further development of the assets.
Continuation funds offer several benefits for both private equity managers and investors. For managers, continuation funds provide an alternative exit strategy that allows them to avoid a fire sale of their assets at unfavorable prices and to retain control over their portfolio companies.
These funds also enable managers to extend their fee income stream and to demonstrate their ability to create value over a longer time horizon. For investors, continuation funds offer flexibility and optionality. Investors who want liquidity can cash out of their investments at a fair market value, while investors who want exposure can stay invested and benefit from the potential upside of the assets.
Continuation funds may also offer investors better alignment of interests with the managers, as well as lower fees and governance rights.
Understanding the Legal and Commercial Challenges
While there are key benefits for investors, continuation funds can pose significant legal and commercial challenges that require careful consideration and planning. Some of the key issues that fund advisors need to think about when advising clients on setting up continuation funds include:
- Valuation: The valuation of the assets to be transferred to the continuation fund is a critical and contentious issue, as it determines the price that the existing fund’s investors will receive or pay for their interests. The valuation process should be independent, transparent and consistent with the existing fund’s valuation policy and industry standards.
- Consent: The transfer of assets to the continuation fund may require the consent of various parties, such as the existing fund’s investors, lenders, portfolio companies and regulators. The consent process should be conducted in a timely and efficient manner, taking into account the contractual rights and obligations of each party and the potential conflicts of interest that may arise. When obtaining consent, it is advisable that limited partners be supplied with sufficient information and disclosures to allow them to make an informed decision. This information may include disclosures about the process for pricing the assets, conflict of interest considerations, and fund terms that would be unique to the continuation fund. To facilitate the consent process, many funds decide to engage registrar and transfer agents and fund administrators.
- Structure: The structure of the continuation fund should be tailored to the specific needs and objectives of the managers and investors, as well as the characteristics and requirements of the assets. The structure should address issues such as the legal form and jurisdiction of the continuation fund, the terms and conditions of the fund agreement, the governance and decision-making mechanisms, the fee arrangements and the tax implications.
- Taxation: From a tax perspective, investors will be interested in understanding whether their interests in the existing fund can be rolled over on a tax free basis, and whether the continuation fund will share the tax characteristics of the existing fund. It is advisable for the general partner to coordinate with existing investors well in advance before the structure of the continuation fund is decided.
- Execution: The execution of the continuation fund transaction involves multiple steps and documents, such as the asset purchase agreement, the fund formation documents, the investor subscription documents, and the financing documents. As most partnership agreements do not contemplate GP-led transactions, the terms of the fund’s existing partnership agreement will need to be revisited. Depending on the jurisdiction and regulatory framework, the establishment of a continuation fund may require approvals from relevant regulatory authorities. Like other GP-led transactions, the United States Securities and Exchange Commission is particularly interested in how conflicts of interest and disclosures are handled by general partners.
Continuation funds are an innovative and attractive solution for private equity funds that are nearing or past their expiration date and have unrealized assets in their portfolio.
However, they are also complex and nuanced transactions that require careful planning and execution and advisor assisting clients on setting up continuation funds need to have a deep understanding of the legal and commercial issues involved.