- Jakub Kozlowski
To Continue or Not to Continue: The Rise of Continuation Funds
The rise of continuation funds, also known as GP-led secondaries, has become one of the biggest trends in private equity. Although continuation funds are not a new concept, they have been used aggressively in recent years. In 2021 and 2022, the total deal volume of GP-led transactions reached $116 billion. This article first explains the structure of a simple continuation fund and the reasons why PE firms adopt them, then discusses the SEC’s proposals which aim to regulate the conflicts of interest inherent in such transactions and concludes that GP-led secondaries are likely going to remain popular despite regulatory and market pressures.
The Mechanics of a Continuation Fund
There are two fund entities in transactions involving GP-led secondaries – the legacy fund and the continuation fund. Both funds are limited partnerships managed by the same GP. The legacy fund holds a number of companies – as an example, Figure 1 illustrates Companies A, B, and C. In a continuation fund transaction, LPs are given two options:
sell their interests and leave the fund, or
“roll” all or part of the interests to the continuation fund. LPs can also invest additional capital in the new fund.
The selling LPs receive cash from new investors purchasing their stakes in the continuation fund. The continuation fund is a newly set-up entity to which one or more companies are transferred from the legacy fund. This transfer can involve several companies or a strip sale in which only some assets of particular companies are sold to the new fund. The type of transfer depends on factors such as the purpose behind the continuation fund and the performance of the transferred companies.
Holding onto Diamonds for Longer
Historically, GP-led secondaries were used to transfer companies in distress when a legacy fund’s lifecycle was coming to an end. If certain portfolio companies performed poorly, exiting investments via IPOs or secondary buyouts (i.e., selling to other PE firms) would not produce satisfactory returns for LPs. In such instances, continuation funds provided more time for PE firms to rehabilitate struggling companies and, hopefully, generate higher IRRs for investors in a few years. This strategy was adopted to protect companies temporarily suffering from lockdowns during the Covid-19 pandemic.
Nowadays, continuation funds serve more purposes. Some companies in the legacy fund become diamonds with promising financial projections. Nonetheless, two problems could arise. First, most of the capital committed by LPs might have already been drawn. This is a challenge for diamond companies that need a liquidity injection for further growth. Second, a typical fund must provide liquidity for investors after 10 years. In other words, the GP must exit investments even if doing so requires selling companies that would otherwise produce high returns in the future. A continuation fund solves both problems. The rolling LPs and new investors provide liquidity to support the growth of the diamonds while the LPs that decide to leave are cashed out. Thus instead of selling valuable assets (for example, to a competing PE firm), the GP holds on to them for longer in the hope of extracting more value via a new fund structure.
The SEC’s Private Fund Reform Proposals
There is an inherent conflict of interest in GP-led secondaries. The legacy and continuation funds are managed by the same GP which owes fiduciary duties to both vehicles. The GP acts as seller for the legacy fund and buyer for the continuation fund. The result is that “it will either turn out to be a better deal for the buyer or for the seller”. In addition (and assuming the hurdle rate is met), setting up a continuation fund allows the GP to receive the carried interest (“carry”) twice. Carry is a 20% share of profits on a sale. The hurdle rate (typically 7-8%) is a minimum return that LPs must receive before GPs are awarded carry. Thus, carry can be paid to GPs when the legacy fund sells assets to the continuation fund and again when that new vehicle makes a subsequent sale. A double paycheck of carry is not in itself controversial. It could be argued that the prospect of getting paid another carry incentivizes the GP to improve the transferred assets for the benefit of all investors. The better the performance of assets, the more carry the GP is going to be awarded again. However, certain circumstances might lead to a conflicted situation. Taking an example from Figure 1, if Companies A and B are performing poorly, but C is the diamond, the GP will have the incentive to transfer C to a continuation fund. This will allow the GP to receive the carry from the transaction involving C. Without the transaction, A, B, and C together would likely miss the hurdle rate which is a contractual prerequisite to receiving the carry.
In 2022, the SEC proposed to reform private funds under the Investment Advisers Act of 1940. The most notable proposal requires the GP to obtain a fairness opinion from an independent provider and disclose any material business relationship it has with the provider. The fairness document opines on whether the price offered is fair. The proposal directly addresses the conflicted role of GPs representing both the old and new investors in continuation fund transactions. It has been argued that the mandatory fairness opinion will increase investor expenses related to the transaction, creating an impression that the reform will harm investors. However, this reasoning is likely somewhat exaggerated because fairness opinions have been commonly used in the past. In fact, LPAC (the body acting on LPs’ behalf from which the GP obtains a conflict waiver) typically requires a fairness opinion to establish whether the transaction is commercially viable to go ahead. The fairness opinion has therefore become a universally accepted expense in the mechanics of the transaction.
The fairness opinion does not ensure the highest price which means that LPAC does not decide on the price terms of the deal. However, other price discovery mechanisms are commonly adopted by PE firms, making the transaction “fairer”. In a transaction involving many bidders willing to invest in a continuation fund, the GP appoints a third-party advisor to run the bidding process. Potential buyers run their own due diligence and determine the price of the assets. This process helps GPs discover the true value of assets and in this way minimize their conflicts of interest. If doubts over the price remain, GPs tend to reinvest some portion of their carry in the continuation fund which further provides comfort to all constituents that the transaction is fair.
Continuation Funds – The Outlook
The proposed regulations do not pose a threat to continuation fund transactions because the use of fairness opinions is already standard practice. Furthermore, the price discovery tools, developed over the years by the industry, exceed the scope of regulatory proposals. In any event, many transactions necessitate LPAC’s formal approval before the sale process can begin. This means that the question of whether the rise of continuation funds will continue depends on market conditions, not regulations.
Covid-19 and inflationary pressures have caused worldwide market volatility. This created the denominator effect pressuring LPs to divest from certain asset classes. As a result, LPs generally choose to be cashed out in GP-led secondaries. Without enough investors, GPs struggle to raise sufficient capital to provide liquidity to existing LPs. However, experts point out that this is a temporary complication. In June 2022, ICG Strategic Equity raised $5 billion for a new continuation fund. In January 2023, Blackstone Strategic Partners accumulated $2.7 billion for its GP-led secondary. Numbers like these highlight the ability of GPs to raise enough capital and cash out LPs struggling with the denominator effect. Most importantly, these examples indicate strong industry signals that the appetite for continuation funds is going to increase despite the challenges that the global markets face today.
Jakub Kozlowski serves as a Graduate Editor of the NYU Journal of Law & Business. He is a Corporations LLM candidate at NYU where he focuses on M&A, private equity and securities law. He is also currently a Research Assistant at the Institute for Corporate Governance and Finance. Prior to attending NYU, Jakub completed the LLB and LPC in England and interned at several law firms in Poland and USA.