Holding On To Diamonds Longer – Continuation Funds

Continuation funds have become one of the biggest recent global trends in private equity. In the past, they were seen in a negative light and were perceived as a tool to restructure underperforming assets. But in the last few years, these funds have shifted focus and turned to strong assets. Similar to IPOs and sales to strategic buyers or another PE sponsor, continuation funds are used as a viable exit solution. Although they can be attractive, they are also complex. This Strelia M&A Series discusses how these funds can help to manage portfolio companies proactively, what challenges they will bring and how to address them, and what the next steps can be.

A tool for proactive portfolio management

A continuation fund allows a PE fund to hold a portfolio company longer than the usual 7-to-10-year fund lifecycle. In a continuation fund transaction, a new special purpose vehicle managed by the same sponsor would acquire one or more assets of an existing fund. The sponsors can thus continue to manage the acquired assets and benefit from all the advantages that come with them. They can also optimize the performance of these investments even more and unlock significant enterprise value by extending the runway and securing additional capital that the existing fund might be unable to provide. Finally, continuation funds give GPs a lot of flexibility. These funds, which are GP-led, enable GPs to raise new capital to fund continued growth opportunities, such as add-on acquisitions, and remake the sponsor’s incentive structure. Investor opportunities might be slightly less apparent—but they can be powerful. Investors in the existing fund could be offered the option to either sell or roll their interests into the continuation fund. And new investors could make a cash contribution to the continuation fund, which provides the necessary liquidity for investors in the existing fund who opted to sell. Both types of investors can negotiate new terms for the continuation fund.

Challenges and how to overcome them

A conflict of interest actually sits at the heart of a continuation fund transaction because the sponsor is on both sides of the deal. This creates governance and process issues that will need to be addressed. The deal valuation is often a main point of debate because the price should be set at a level that satisfies the investors who want to cash out. At the same time, it should not be so high that drives away new investors. The valuation will clearly have an impact on the GP’s incentive allocation. Overall, the GPS must ensure that the transfer of the assets, the fees to the LPs and the pricing of the assets are done at arm’s length. To address this challenge, GPs have adopted different strategies. For example, they would organize competitive auctions or recurring third-party evaluations, and potentially, seek a review from a formal investment committee and an independent third-party fairness opinion.

Another challenge when dealing with continuation funds is the short time span for LPs to choose which course of action to take. LPs typically pay GPs to make the decision to buy, hold or sell, but in a continuation fund transaction, the liability shifts from the GP to the LPs. Many LPs choose to sell as an informed decisions would require a specific asset-level due diligence that they are not accustomed to. Detailed and advance disclosure about the rationale behind the recapitalization and a reasonable timeline that gives LPs ample time to evaluate their options will pave ways for a smoother process.

Another challenge is the asset concentration of the investors’ risk. This lies either in one single asset or a handful of assets, but not spread out over many underlying assets. Investors should thus consider how much concentration risk they are willing to accept.

What next?

Although industry practice is not yet fully established concerning continuation funds, we see more rigorous processes for these transactions through the creation of transparency in the options, benefits, costs and the process. The SEC also proposed new rules recently for advisor-led secondaries. These rules would result in extra reporting requirements and procedures. With continuation fund transactions on the rise, we expect to see this tool embedded in practice and its terms of use harmonized. There will be more fund documents used that illustrate how a continuation fund can take place.

Gisèle Rosselle

Céderic Devroey

Marie-Elisabeth Dubois