The private equity (PE) secondaries market is witnessing continued growth, both globally and especially in recent years, within the Asia-Pacific region.

Managers are increasingly seeking ways to actively manage their trophy assets (and to some extent, their distressed assets) and to proactively generate liquidity for their investors. The secondaries market has become more attractive in the wake of recent events—including the pandemic, geopolitical tensions, volatile public markets and the underperformance of certain sectors—all of which are creating a challenging environment for exits and pushing managers to find alternative solutions to provide liquidity.

General partner-led restructurings and, in particular, continuation funds, have been viewed as one of the potential means to bridge the gap in providing liquidity to managers and their investors. Continuation funds are typically set up and managed by the same manager selling the asset(s). Instead of selling the asset to a third party, the manager of an existing fund sets up a new vehicle and rolls the asset from the existing vehicle into the new one.

Given that the manager sits on both the sell- and buy-sides, continuation funds have been controversial due to perceived conflicts of interest. This article offers some of the key points for investors—on both the buy and sell sides—to consider when participating in a continuation fund transaction.

What is a continuation fund?

Historically, continuation funds have been used in situations where a manager or sponsor is unable to sell a problematic or distressed asset at the end of the fund’s life. More recently, continuation funds have been designed to achieve two outcomes: to enable managers to retain their well-performing assets as their existing funds near the end of their terms, allowing for later exits at more optimal times, and to allow existing investors seeking liquidity to cash out of their investments. In addition, it is common for new investors—often market participants in the fund secondaries industry—to be brought in as investors in the continuation fund.

The sponsor will typically also commit to the continuation fund—often using the carried interest earned from the existing fund that crystalized upon the rollover—to ensure better alignment with its investors.

A typical continuation fund structure is set out below:

View full image: Continuation fund structure (PDF)

Investors in the existing funds who choose not to cash out on the sale of the portfolio company or asset have the option to roll over their interest by taking an equity stake in the newly-established continuation fund for the specific purpose of purchasing the portfolio company or asset.

The same sponsor or manager will often continue to manage the assets of the continuation fund. Additional capital commitments in the continuation fund may be earmarked for follow-on investments.

Perspectives of the parties

In a continuation fund restructuring, investors who choose to roll over their interest will often subscribe for a new interest in the continuation fund as part of that rollover. These investors have the advantage of a longer term hold on an investment, which can be beneficial in terms of retaining significant upside potential. They also may be given the ability to retain their existing terms of investment or otherwise renegotiate new terms. As part of subscribing for a new interest in the continuation fund, an investor may also be asked by the sponsor to subscribe for a “stapled interest” in a newly-raised primary fund established by the sponsor. On the other hand, an investor who elects to cash out has the benefit of receiving liquidity on its investment—when no such liquidity might otherwise exist—locking in unrealized gains and gaining the ability to rebalance and de-risk their portfolios and re-deploy their capital elsewhere.

Sufficient time and transparency will be key factors for investors who are deciding whether to cash out or roll over their fund interests. On the buy-side, secondaries opportunities are attractive to investors as they provide them with exposure to mature, pre-identified assets or portfolios with holding periods that are shorter, relative to the holding period of a primary fund. Key considerations for investors on the buy-side typically focus on due diligence on the underlying asset or portfolio, valuations, any competitive bidding processes and the negotiation of the terms of the proposed continuation fund. In situations where a consortium of investors will be involved, there may be one or more lead investors who take a more active role in the bidding process and negotiate with the manager, while the other investors take a more passive role.

Finally, as previously noted, the manager will continue to manage the asset and to receive fee and income from the asset. Management fees in continuation vehicles are often charged out at a lower rate than management fees payable on a primary fund, and carried interest is often tailored for stronger alignment. Managers will frequently push for a super carry—sometimes a higher carry percentage than the one used in the existing fund, for example, 25 percent in the continuation fund versus 20 percent in the existing fund, or a tiered carry where the carried interest percentages ratchet up to 25-30 percent as the continuation fund hits its return targets.

Conflicts of Interest

While there are advantages to tapping into the growing secondaries market, continuation funds often present significant legal and commercial issues that must be considered. Conflicts of interest are one area that often require close scrutiny.

The conflicts primarily relate to the fact that the manager sits on both the sell-side (i.e., the existing fund) and the buy-side (i.e., the continuation fund). This often leads to a perceived conflict regarding the pricing of the underlying assets, and the manager’s motivation in selling the asset to a related vehicle. There are particular concerns regarding the economic terms that the manager may receive from investors in that vehicle (i.e., often higher carry and a continuation of the fee income in the form of management fee).

To address this potential perceived conflict, it is not unusual for a manager to bring the transaction to the existing fund’s investor advisory committee or board for approval. While this often helps mitigate any potential conflict on the manager’s part, in some situations it may not be adequate as the investors (or their representatives who sit on the fund’s investor advisory committee or board) may themselves be perceived to have a potential conflict if they also sit on both sides of the transaction (due to their investments in both the existing fund the new continuation fund).

A thorough review and knowledge of the fund documents is often important so that both the manager and the investors understand their rights and obligations in any proposed continuation fund transaction. Various mechanisms can be put in place to potentially regulate conflicts—including a requirement for investor consent or an independent valuation of an asset, and recusal requirements at the investor advisory committee or board level where a potential conflict of interest exists. These issues may need to be considered upfront; in particular, some managers are beginning to hardwire the express ability to create continuation funds as part of the main fund establishment process, specifying the requirements (often investor advisory committee or board consent or a form of price validation) needed for the main fund to transfer an asset to a continuation fund.

Regulators are also starting to pay attention to conflicts of interest in these transactions. The SEC, for instance, has recently proposed rules that would require the issuance of a third-party fairness opinion for any adviser-led secondary transaction, in addition to a summary of any material business relationships the adviser or any of its related persons has, or has had, within the past two years, with the independent opinion provider.

Conclusion

GP-led restructurings come in many forms. A successful GP-led restructuring is a win for all parties. Alignment of interest, transparency and adequacy of information, actively managed conflicts, continuous dialogue and a well-planned timetable are critical to achieving this result.

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_{This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.}

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