Over the past five years, secondary fund structures like continuation funds have gained significant traction in private equity. Continuation funds, in particular, have proven to be a useful tool for general partners (GPs) navigating challenges such as market volatility, regulatory uncertainty, or other operational challenges, which may complicate exits. These structures not only offer liquidity to limited partners (LPs) but also provide LPs with the option to stay invested and potentially benefit from future upside.
What is a Continuation Fund?
A continuation fund is established to acquire some or all of the remaining assets from an existing fund and continue to manage them for a longer period. Existing investors can sell their interests to the continuation fund or roll them over to participate in the new fund. To finance the acquisition of the continuation fund and further develop the portfolio investments, the GP will raise additional capital for the new fund.
Key Benefits of Continuation Funds for GPs and LPs
Continuation funds offer several benefits for GPs and LPs. For GPs, this fund structure addresses LPs’ liquidity needs while preserving long-term relationships. The structure also allows GPs to extend the time horizon of investments, accommodating LPs seeking liquidity and those who prefer continued exposure to the fund assets. This creates an opportunity to capture additional upside by managing assets for longer durations and optimizing returns.
For LPs, continuation funds provide flexibility by offering a choice between exiting their investment or staying invested under a new structure. This option is valuable after a long investment period, especially for LPs who seek liquidity. Additionally, LPs benefit from the continued alignment with GPs who remain incentivized to maximize performance and raise new capital.
Understanding Challenges of the Fund Structure
While there are clear benefits for GPs and LPs, continuation funds can pose challenges that require careful consideration and planning.
- Valuation: The valuation of the assets to be transferred to the continuation fund is critical as it determines the price the existing fund’s investors will receive or pay for their interests. Changes in market conditions, regulatory environments, or the financial health of the portfolio companies complicate the valuation process. Accurately assessing these factors requires an independent, transparent, and consistent approach.
- Consent: The transfer of assets to the continuation fund may require the consent of various stakeholders, including existing fund investors, lenders, portfolio companies, and regulators. The consent process should be conducted efficiently, taking into account potential conflicts that may arise.
- Fund Structure: Structuring continuation funds presents several challenges, primarily due to the need to balance the interests of both existing and new investors while complying with regulatory requirements. The structure should address issues such as the legal form and jurisdiction of the continuation fund, the terms and conditions of the fund agreement, and the fee arrangements.
- Taxation: Continuation funds encounter significant tax challenges due to their unique structure and extended lifespan. One key issue is managing the tax implications of transitioning assets from the original fund to the continuation fund to avoid realizing taxable gains.
- Costs: The transition from the original fund to the continuation fund often involves significant upfront costs, such as restructuring fees and expenses related to securing new investor commitments.
Alternative Fund Structures
Alternative fund structures to continuation funds offer various approaches for managing investments beyond the original fund’s lifespan. One of these structures is a strip sale. A strip sale is when the GP sells a portion of the fund’s portfolio investments to an investor or group of investors, offering liquidity to LPs. This structure allows the fund to partially capture any increase in the portfolio assets’ value at the time of the sale while allowing LPs to benefit from further upside through the fund’s retained stake in the asset(s).
A strip sale offers several benefits to both GPs and LPs, namely liquidity, flexibility, and risk management. For LPs, selling a portion of the fund’s assets enables them to access liquidity without fully liquidating their investment in the fund. For GPs, a strip sale allows for strategic restructuring of the fund, potentially enhancing future returns. By selling a portion of the assets, GPs can mitigate market risk and avoid the potential negative impact of a market downturn on the entire portfolio.
The Road Ahead
Continuation funds and similar structures are an attractive solution for private equity funds nearing their expiration date and have unrealized assets in their portfolio. They offer distinct benefits and challenges to both GPs and LPs and, therefore, require careful consideration and planning to understand the short-term and long-term implications.
At VIRDIS Fund Solutions, we work closely with private equity GPs on their fund and operational structuring needs to identify tax-advantageous solutions and align the interests of GPs and LPs. To learn more about our fund solutions, please visit our website.