The historically illiquid private equity market has found a new path to tradability through the private equity secondaries market and continuation funds. The secondaries market was once a niche market characterized by distressed sellers looking to exit certain long-term difficult-to-exit positions. It has since become an active marketplace.

GPs and LPs have become increasingly attracted to the continuation fund market as an alternative to more traditional exits given uncertainty in public markets and headwinds in credit markets.

In the wake of this unease, geopolitical risks and underperformance in certain sectors, fund sponsors and GPs have turned to continuation funds to actively manage and extend the runway of their best performing portfolio companies, generate additional value for those companies and generate liquidity for investors without the typical term constraints associated with primary funds. 

For LPs, continuation fund transactions with high quality sponsors may provide an opportunity to leverage the GP’s knowledge of the underlying asset, collaborate with the GP in enhancing the value of the asset and negotiate deal terms that align the interests of the GP and the LPs. 

GP-Led Secondaries and Continuation Funds

GP-led transactions are distinct from traditional secondary deals.

• GP-led transactions often restructure the ownership of one or more assets within their funds while providing a liquidity option to existing LPs. GP-led transactions are structurally bespoke, with continuation fund transactions accounting for about 80% of GP-led transactions in recent years.^[1]
• A traditional secondary transaction involves an LP selling its interest in one or more partnerships. An LP approaches potential buyers and then transfers its partnership interests to a buyer, typically with GP consent.The buyer becomes an LP and takes on the seller’s future obligations to the fund.

A continuation fund transaction is a specific type of GP-led secondary transaction, which involves a sponsor-advised fund selling one or more portfolio companies to a newly formed continuation fund that is managed by the same sponsor and formed for the purpose of acquiring the portfolio companies. 

These transactions involve the creation of a new investment vehicle (the continuation fund), typically structured as a separate fund.  These separate continuation funds are formed primarily to:

• Provide an extension of the holding period for select portfolio companies beyond the end of the selling fund’s lifespan (typically 10 years);
• Tap additional unfunded commitments from new and rolling investors; and
• Increase dry powder for follow-on or add-on investments.

Continuation funds also allow the GP to:

• Extend the life of the selling fund at a time when the selling fund may be fully deployed or unable to deploy capital because of restrictions included in its limited partnership agreement; and
• Potentially use or restructure portfolio company-level debt when it might not otherwise be able to do so.

Continuation funds also allow the GP and the new lead investors to negotiate new terms and economics, including arrangements around fees, carried interest and governance. 

In continuation fund transactions, the incoming LPs can benefit from the GP’s knowledge of the underlying asset, collaborate with the GP to further enhance the value of the asset and negotiate deal terms that more closely align the interests of the GP and the investors.

In continuation fund transactions, existing LPs in the selling fund are typically provided options to:

• Sell their interests and receive a pro rata portion of the cash purchase price of the asset sale;
• Roll their pro rata share of their selling fund interests into the continuation fund (or sometimes into a “rollover vehicle” which holds a pro rata portion of the assets sold in the transaction); or
• Sell a portion and roll a portion of their interests.

The LPs in the selling fund that elect to be cashed out, in whole or in part, are cashed out using proceeds contributed to the continuation fund by the new investors. Those LPs may need to meet certain liquidity needs or adjust asset class allocations in response to changing market conditions.

Rolling investors many times are given the option to retain their terms of investment or roll under the new terms negotiated by the new lead investors.  Those new terms may be more LP favorable; however, in single asset GP-led transactions, existing investors are more often only given the option to cash out or roll on the new terms negotiated by the new lead investors. 

To align incentives between the GP and the rolling and new investors and to participate in any additional upside on the portfolio companies, the GP will often roll its entire crystalized carried interest into the continuation fund structure. 

Continuation Fund Market and Trends

The secondaries market has grown substantially in recent years, in large part due to the growth of GP-led deals.  GP‑led transaction volume increased from $26 billion in 2019 to $68 billion in 2021, before moderating to $52 billion in 2022.^[2] 

In 2016, GP-led transactions represented 24% of the secondaries market; however, by 2021, GP-led transactions represented 52% of all secondary transaction volume.[3]  GP-led transactions and continuation fund transactions have gained in popularity, including among growth equity and other non-buyout private fund strategies.  Other positive indicators include a slew of larger secondary funds raised, higher allocations to GP-led secondary transactions in such funds and the arrival of certain secondary funds formed solely to invest in GP-led secondary transactions and continuation fund transactions. Evercore estimated that close to $50 billion of capital was available for GP-led secondary transactions as of December 31, 2022.^[4]

As continuation fund transactions have grown in popularity, the strategy behind the transactions has also continued to evolve.  Long used for struggling portfolio companies to extend the holding period and increase the chances of a potential turnaround of such low performing portfolio companies, continuation funds have more commonly become vehicles that let:

• GPs hold on to promising portfolio companies for a longer period, avoiding suboptimal exits and potentially realizing higher returns as market conditions change;
• Selling investors calibrate their liquidity profile and exposure to different asset classes and receive liquidity on their investments when liquidity may not otherwise be available; and
• New investors obtain exposure to high-performing and de-risked assets with shorter runways to liquidity and access to preferred fund sponsors and GPs.

Benefits of a Continuation Fund

Continuation funds provide many benefits that traditional exits may not.  For example, continuation funds allow existing investors in a primary fund to be given the option to lock in gains on successful portfolio companies while allowing the GP and the rolling and new investors to have access to such portfolio companies for longer than the primary fund’s term. 

Continuation funds allow existing investors to access liquidity, rebalance and de-risk their portfolios and re-deploy their capital elsewhere.

Continuation funds allow rolling investors to:

• Continue their investment in generally high-performing portfolio companies that they know well, for a longer period than is permitted under the existing fund’s organizational documents; and
• Realize any additional upside on the portfolio companies upon a potentially more favorable future exit.

For new investors, continuation funds provide a way to invest in mature, pre-identified and generally high-performing portfolio companies with holding periods that are shorter relative to the holding period of a primary fund, alongside a GP that has managed and is familiar with the portfolio companies. 

Continuation funds may also benefit the underlying portfolio companies by providing continuity with a sponsor that knows the portfolio companies well, which can avoid potential disruption from new ownership resulting from a sale or other liquidity event.  Further, the extended investment period on high-performing portfolio companies allows more time for the GP and the rolling and new investors to realize upside potential and to do so without locking in their investment for the longer additional term of a primary fund.

Continuation funds also can provide an opportunity to the GP to access additional dry powder in the form of additional unfunded commitments from the rolling and new investors and from the GP itself, which additional unfunded commitments allow the GP and the portfolio companies to further capitalize on attractive add-on opportunities in the market. 

Additionally, continuation fund management fees are often structured at a lower rate than management fees payable on a primary fund, which, together with carried interest that is tailored for stronger alignment, can further strengthen the alignment of interests between the involved parties.

There has been a market shift with LPs and other market participants no longer seeing continuation funds as a way for underperforming sponsors to extend the life of portfolio companies, but instead looking to continuation funds as a key to unlocking value in high performing assets.  

Potential Challenges with a Continuation Fund

Conflicts of Interest

While continuation fund transactions present many benefits, they can also present potential legal and commercial challenges that must be considered and addressed by sponsors.  

The perception of conflicts of interest can arise from the fact that the GP has interests in both sides of the continuation fund transaction—on the sell-side of the transaction as the GP of the selling fund and on the buy-side of the transaction as the GP of the continuation fund.  This can create uncertainty regarding the pricing of the portfolio companies being sold to the continuation fund and the GP’s motives in engaging in the transaction.

Additionally, existing investors of the selling fund may question any new distinct terms and economics, including arrangements around fees, carried interest and governance, that apply to the continuation fund, as such terms and economics are negotiated between the GP and the new lead investors and the existing investors of the selling fund can be put in a position to choose to sell or roll over into less favorable terms.

The GP can address the perception of potential conflicts of interest by, among other things:

• Exploring alternative options for the portfolio companies;
• Presenting the rationale for the continuation fund transaction to the primary fund’s limited partner advisory committee (LPAC) or even directly to its LPs as early as possible and prior to a formal proposal to run a transaction process or to hire an advisor;
• Keeping the LPAC and LPs updated throughout the process;
• Presenting any potential conflicts of interest arising in connection with the continuation fund transaction to the LPAC as soon as such potential conflicts arise, even if potential conflicts are pre-cleared under the existing fund’s organizational documents;
• Requesting that the LPAC vote to waive all such potential conflicts of interest; and
• Running a competitive process (such as an auction that solicits multiple competing offers) to ensure a fair price for the portfolio companies and soliciting a third-party fairness or valuation opinion to validate the valuation of the portfolio companies, as discussed further below.

GPs can also address potential issues with rolling LPs by, among other things, ensuring that there is no:

• Increase to management fee basis or percentage for rolling LPs;
• Increase to the carried interest rate or decrease to the preferred return hurdle for rolling LPs; and
• Crystallization of carried interest for the rolling LPs.

The Institutional Limited Partners Association (ILPA) has provided additional guidance on best practices for successful continuation fund transactions that may be helpful for sponsors and GPs who find themselves considering a continuation fund transaction. While these actions often help to mitigate potential conflicts on the GP’s part in a continuation fund transaction, in some situations, such actions may not fully resolve potential conflicts. 

Process and Timing

Another potential challenge for continuation fund transactions is the tight timelines that have historically accompanied such transactions. Those timelines may hinder the LPAC’s ability to determine whether a potential conflict should be waived or an existing investor’s ability to determine whether to roll its investment into the continuation fund. 

To streamline the continuation fund transaction process and to help GPs understand their rights and obligations, GPs should work with experienced advisors to conduct an early and thorough review of the primary fund’s governing documents.  Further, in order to facilitate the waiver of any potential conflicts by the LPAC and to facilitate the roll or sell decision from the existing investors, the GP should ensure that it and its advisors disclose to the LPAC and the existing investors in a timely manner necessary information about the:

• Portfolio companies;
• Continuation fund transaction process, including the price discovery process and the solicitation of a fairness or valuation opinion;
• Rationale of the continuation fund transaction and alternatives that were considered;
• New economic fund terms, if any, negotiated with the new lead investors; and
• Bids.

Timely disclosure and adequate transparency are imperative so that the LPAC and existing investors have sufficient time to make informed decisions and so that the GP can demonstrate that the interests of the involved parties are aligned.  Generally, existing investors should be afforded at least 20 business days or 30 calendar days to decide whether to roll their investment into the continuation fund.  Such time period is intended to allow the existing investors to complete their diligence, review the applicable disclosure documents and conduct any necessary internal approval processes before they make a decision on whether or not to roll.  Adequate disclosure and timing and early involvement of the LPAC can help minimize challenges to the continuation fund transaction and facilitate a smooth and efficient process.

Regulation

Recently there has been increased scrutiny from the SEC around GP-led secondary transactions. On August 23, 2023, the SEC adopted Rule 211(h)(2)-2 which became effective on September 14, 2023 and requires registered investment advisers in an “adviser-led secondary transaction” to distribute to investors, prior to the date such investors must make a binding election for such transaction, both:

• A fairness opinion (stating that the price being offered for any assets being sold is fair) or valuation opinion (detailing the value of the assets being sold) from an independent opinion provider; and
• A written summary of any material business relationships that the adviser or any of its related persons has (or has had) with the independent opinion provider in the two years before the opinion is made.

The SEC defines “adviser-led secondary transaction” to include any transaction initiated by an adviser or its related persons that offers fund investors the option between selling all or a portion of their interests in the private fund and converting or exchanging them for new interests in another vehicle advised by the adviser or any of its related persons. 

The SEC has said it would not view a transaction as “initiated by the adviser” if the adviser, at the unsolicited request of the investor, assists in the secondary sale of such investor’s fund interest.  Further, a tender offer will not be considered an adviser-led secondary transaction for the purposes of this rule if an investor is faced with the decision between (i) selling or (ii) converting or exchanging all or a portion of its interest. Sponsors and their GPs should be mindful of these additional requirements when conducting a continuation fund transaction.

Sponsors with $1.5 billion or more in private fund assets under management must comply with this rule by September 14, 2024. The compliance date for this rule for sponsors managing less than $1.5 billion in private fund assets is March 14, 2025.

On September 1, 2023, a coalition of private fund industry organizations filed a petition in federal court seeking judicial review of these newly adopted SEC rules, including the portion of the rule regarding adviser-led secondary transactions.

Conclusion

GP-led transactions, and continuation fund transactions in particular, will likely continue to be utilized by sponsors and other strategic investors as part of a diversified arsenal that allows GPs and their investors to realize higher returns on well-performing portfolio companies and access liquidity outside the bounds of normal fund term constraints.

[1] https://www.nb.com/en/global/insights/whitepaper-the-rise-of-gp-led-secondaries

[2] https://www.jefferies.com/CMSFiles/Jefferies.com/files/IBBlast/Jefferies-Global_Secondary_Market_Review-January_2023.pdf

[3] https://www.preqin.com/insights/research/blogs/gp-led-secondary-transactions-are-transforming-the-private-fund-landscape

[4] Evercore, 2022 Secondary Market Synopsis.