Sonia Bhasin, General Counsel
Private equity managers facing contractual, end-of-fund deadlines for returning capital to investors are increasingly turning to continuation funds to acquire and manage private equity fund assets for longer periods.
These continuation funds, also known as general partner-led secondary funds, provide critical elements for private equity fund managers—time and flexibility—and serve as important vehicles to help private equity fund managers maintain returns and manage risk.
As a fund approaches the end of its existence after a decade or so, it’s common to see market conditions change. Increasingly, fund managers are facing turbulent market conditions, increased volatility and shifting regulations that pose challenges for selling assets and generating sufficient returns for investors.
To avoid selling assets at a loss, private equity fund managers can ask investors to sell at fair market value or roll their interests in assets into the continuation fund and benefit when market conditions improve. With the continuation fund, managers not only retain the portfolio assets and fee income stream, but also have the opportunity to raise new capital to expand and develop new assets.
At MUFG Investor Services, we help clients understand that establishing continuation funds requires deft handling of a range of issues—valuation, consent, structure, taxation and execution—to ensure that investors are protected and that fund managers can effectively execute the continuation strategy.
For example, investors must have a clear guidance on how the transferring assets will be valued, whether they are being cashed out or transferred. That valuation process must be independent, transparent and consistent with industry standards and the existing fund’s policies. The consent process for transferring assets must be timely and closely coordinated among investors, lenders, portfolio companies and regulators. Investors must receive appropriate disclosures and information—ranging from asset pricing to potential conflicts of interest and unique fund terms—to ensure they are making informed decisions. In some cases, managers should consider hiring registrars, transfer agents and fund administrators to coordinate the consent process.
In addition to reflecting the needs and objectives of the managers and investors, the continuation fund structure should address issues including its legal form and jurisdiction, terms and conditions of the fund agreement, governance and decision-making mechanisms, fee arrangements and tax implications. From a tax perspective, general partners should coordinate with existing investors well before the continuation fund structure is decided. That way, investors will know if tax characteristics of the new fund will mirror the existing fund, as well as any tax implications if their interests are rolled into the new fund.
Creating the continuation fund and executing the transactions require review of the existing partnership agreement, as well as coordination of documents, including an asset purchase agreement, and fund formation, investor subscription and financing documents. In some jurisdictions, continuation funds may require approval from regulators including the US Securities and Exchange Commission.
Once established, we’ve seen continuation funds help our clients and their investors navigate a challenging macroeconomic environment—increasing returns and providing liquidity—in a way that clearly benefits all parties.