The Rise of Continuation Funds: Key issues and industry best practices that GPs should keep on their radar

Over the past twelve months, the private market has seen the most difficult conditions in more than a decade with persistent inflation, interest rates rising, declines in fundraising and deal activity. In this challenging climate, sponsors (GPs) have found it more difficult to exit assets at attractive valuations constraining distributions to investors (LPs). In this context, secondary transactions have grown significantly providing liquidity to long-term illiquid asset classes. Indeed, despite private fund-raising contraction, across the private market, secondaries fundraising almost doubled in 2023¹. In 2024, it is expected that the global secondary private market will reach approximately $140 billion in size².

Traditionally, secondary transactions happen where, following an investment made in a fund structure, an existing LP wishes to sell its limited partner interest(s) to a secondary buyer to exit the fund structure early. In exchange, the secondary buyer (i) will pay an agreed price to the existing LP and (ii) the secondary buyer will step into the shoes of that existing LP. This is known as LP-led secondary transactions. 

Alongside LP-led secondary transactions, the private market is increasingly witnessing secondary transactions initiated and led by GPs, known as GP-led secondary transactions. These typically include tender offers, portfolio strip sales and stapled transactions.  However, the most popular trend for the last few years in this space has been the structuring of continuation funds, offering upside, liquidity and flexibility for both GPs and LPs. 

In this article, we will consider the dynamics of continuation funds as well as the key issues and industry-led best practices that GPs need to keep on their radar when using them. 

1. The dynamic of Continuation Funds

• Continuation fund structure

In a typical private equity fund model, one of the significant features is the limited duration of the funds. Private equity funds typically have a duration of around 8 to 10 years with an option to extend the fund for a further one or two years, subject to the consent of the limited partners (whether through an advisory committee (LPAC) or an all partners vote).  Once the fund term has expired, its assets are then liquidated and distributed to the LPs. However, liquidating an asset when the fund term expires may not optimise the returns from that asset, as it may have further value creation, growth and future returns potential. In a continuation fund, instead of liquidating such an asset, GPs retain it beyond the fund’s term by selling it from the existing fund (a legacy fund) to a newly established fund, a continuation fund. Existing LPs which invested in the legacy fund, have the option of either rolling over their interests into the continuation fund or selling out (i.e. exiting the fund) or a combination of the two.  In addition, new LPs can enter into the continuation fund and can therefore invest in more “mature” assets on a non-blind-pool basis. 

• The concept of “trophy assets”

Historically, continuation funds were used for distressed assets that were struggling in the aftermath of the 2008 global financial crisis; but at that time they were referred to as “restructuring funds”. However, back in 2015, GPs realized that their “restructuring funds” could be a useful portfolio management tool not only for distressed assets, but also for high performing or trophy assets. 

From a GP perspective, using continuation funds provides a tool by which they can maintain continued exposure to their trophy asset(s) beyond the fixed term of the legacy fund at the same time as exiting them from it, thereby enabling the distribution of the returns created to the LP-base in place prior to liquidation of the legacy fund. 

Today, “trophy” continuation funds are structured either as single-trophy asset or as multi-trophy assets vehicles. 

2. Key issues and industry-led best practices that GPs should keep on their radar 

As the structuring of continuation funds evolved, key issues and related industry-led best practice principles solving those issues started to emerge. In 2023, the Institutional Limited Partner Association (the ILPA) published guidance on continuation funds³ that sets out best practice guidance on how to manage the key issues they raise. 

• Conflicts of interest

The establishment of a continuation fund inherently creates a conflict of interest. In a continuation fund transaction, the legacy fund and the continuation fund are managed by the same GP and the GP will typically control both the seller and the buyer in the transaction. 

Therefore, for these transactions, the role of the LPAC is key to manage these conflicts. The GP should discuss the transaction with the LPAC of the legacy fund as early as possible and provide any information needed to enable it to waive the conflicts that arise due to the transaction. It is best practice to allow the LPAC to appoint an independent legal adviser to help it with this process, in addition to the GP-selected adviser. 

Furthermore, as the GP will be involved in the negotiation, valuation, and pricing process of the asset(s) to be sold from the legacy fund to the continuation fund, the GP ought to conduct a competitive valuation process, including third-party validation of the price to ensure that the asset(s) are transferred between the fund at a fair and market price.  

• Alignment of interests: GP “skin in the game”

As a general principle, it is expected that the interests of the GP will be aligned with those of the LPs for the purposes of these transactions, as the GP will typically have “skin in the game” in respect of the continuation fund. The GP will therefore roll over all or part of its carried interest earned in respect of the performance of the legacy fund into the newly formed continuation fund. 

In the majority of continuation funds that have closed in 2023, GPs reinvested 100% of their carried interest in line with the ILPA Guidance. However, depending on the type of distribution waterfall used in the legacy fund (i.e. European-style or US-style), the amount of the GP’s commitment to the continuation fund will be a key point of negotiation to ensure that the interests of the LPs of the continuation funds and the GP are aligned. 

• Managing the election process

In addition to conforming to the relevant rules set out in the legacy fund limited partnership agreement and any LP side letters agreed with legacy LPs rolling their interest in whole or part into the continuation fund, it is expected that the GP should provide these rolling LPs with a minimum time frame within which to make their continuation decision with a clear indication that if they do not actively decide to roll their interest, the default position will be that they exit.

In terms of timing, LPs of the legacy fund should be given at least 30 calendar days/20 business days to have the possibility to thoroughly evaluate the GP proposal and make their election to roll their LP interests into the continuation fund, purchase additional interests; sell a portion of their interests, or a combination of the three or alternatively entirely exit the structure. 

Where LPs fail to make their election in due time, the default position should be treated as an LP exit (i.e. liquidating their interest(s)) as LPs should never be forced to roll their interests into the continuation fund in the absence of a positive confirmation. 

In terms of consistency, rolling LPs’ side letters should continue to apply (insofar as relevant) in respect of the continuation fund.

Finally, the continuation transaction’s advisors (including the GP's selected counsel) should be accessible to LPs at appropriate times. 

• Proposal management – reset or status quo basis

As a general principle, LPs should be offered the opportunity to roll over their interest on either a reset or a status quo basis and no minimum threshold roll participation should be imposed when offering this option. On a reset basis, the LPs participate in the continuation fund on updated economic terms, and the GP of the legacy fund locks in its profits and agrees new terms for managing the rolled over asset(s), including potentially modified carried interest and management fee arrangements. On a status quo basis, the LPs participate in the continuation fund on substantially the same economic terms to those applying in the legacy fund in respect of the management fee the carried interest rate and the preferred return hurdle.

Where there are differences in terms between existing and rolling LPs, the GP should be expected to provide full disclosure around those terms and the reasons for these differences. 

Clearly, continuation funds transactions offer many advantages, providing liquidity for LPs as well as providing an efficient portfolio management tool for GPs. However, with greater flexibility comes additional responsibility; continuation funds transactions bring unique challenges that need to be kept on the radar of any GP involved in such transactions, in particular from a conflicts of interests, economic and governance perspective.