In May, the Institutional Limited Partners Association (ILPA) introduced its long-awaited guidance on Continuation Funds. LPs have, in ILPA’s view, become “increasingly frustrated” with timeframes and economics in these complex but common transactions. The guidance is intended to help LPs “navigate the challenges” that these transactions can present.
The guidance opens by recognizing that continuation funds are here to stay, and acknowledges that they have become a popular option for both GPs and LPs to maximize returns. It then dives into its key criticism: the transactions are complex and the timeframes are short, and LPs cannot evaluate them satisfactorily in time. The guidance then offers its recommendations, many – but not all - of which reflect existing market practice, and which are intended to “reduce strain on the alignment of interest between LPs and GPs.”
Disclosure and process
The main thrust of the guidelines is around disclosure and process, allowing LPs sufficient information and time to evaluate the proposed transaction. To this end, ILPA recommends disclosure by the GP of the process for soliciting bids, the bids received, any favourable economics or different terms for bidders (including staples), new capital required, participation of LPAC members as bidders, exclusion of any bidders, and any changes to the economics or other terms compared to the original fund, for example, key person obligations.
LPs should have equal access to information, as well as access to the transaction advisor, and where relevant for regulatory or other reasons, should be afforded additional time.
Timing and failure to respond
ILPA expressed concern that GPs are not giving LPs sufficient time to evaluate what are often complex transactions which require a re-underwriting of the investment. Some transactions afford LPs no more than 10 days to decide. This has led LPs to take the liquidity option as the default position, rather than on a considered basis.
ILPA’s proposal is for LPs to have 30 days to decide to sell or roll. In a reversal from its previous position, ILPA now recommends that where an LP fails to respond, it should be treated as selling, with the rationale that an LP should never be forced to roll its interest into a new vehicle.
Status quo option and rollover of carried interest
Where investors elect to roll into the continuation fund, they should be no worse off than they would have been in the existing fund if there had been no transaction. In particular, there should be no increase to management fees or carried interest or decrease to hurdle rates.
Carried interest should not crystallize for rolling LPs and all carried interest payable on selling LPs’ stakes should be rolled by the GP into the continuation fund.
Rationale and conflicts
The primary rationale should be to maximize value for existing LPs and ILPA suggests heavy scrutiny where the transaction occurs, effectively, within the investment period of a fund.
ILPA considers that, with the GP on both sides of the trade, the transaction is “conflicted” by nature. It confirms that the process should comply with the existing fund documents, but then goes on to state that all parties should avoid LPA terms that pre-clear conflicts. In doing so, ILPA appears to suggest that, where an LPAC vote may not be required under the terms of the existing fund’s LPA, GPs should ignore the LPA. This is unusual and is unlikely to be followed in practice; instead LPs may in future scrutinize any such terms at the fundraising stage.
Price validation and the role of the LPAC
A competitive process should be run to ensure a fair price is achieved, and it should include third party price validation. The LPAC should be entitled to request a fairness opinion in certain circumstances.
ILPA sees the role of the LPAC as central to the process. It should review the choice of advisor including its fee level and components, and other commercial terms. This appears to vest the LPAC with powers that they will not necessarily want. The role of the LPAC is typically to consent (or not) to transactions involving potential conflicts of interest, not to insert itself between the GP and the fund’s advisors and advise on deal terms. Some LPs have withdrawn from LPAC duty over the years, citing concerns over workloads or liability, and the suggestion that they should take on additional responsibility for deal terms is unlikely to sit well with them.
Recommendations for LPs
To assist LPs to navigate transactions, ILPA has set out a set of recommendations, including adopting internal protocols to ensure they can respond in the required timeframe. Part of the recommendations relates to due diligence during fundraising: as well as assessing how potential conflicts will be dealt with, ILPA recommends that LPs assess the GP’s past use of continuation funds as part of the primary commitment process.
Likely impact
When ILPA introduced its original Principles in 2009, they were seen as a gamechanger in relations between GPs and LPs. GPs got used to preparing a gap analysis of their fund terms as against the ILPA Guidelines, and to justifying departures (the joint and several “gross of tax” clawback being an obvious one that was diluted in subsequent versions of the Guidelines).
Take-up of the model LPA, another initiative, has been less enthusiastic, so it will be interesting to see how much traction these continuation fund guidelines gain, either in relation to timing and process or the substantive terms. Much of the substance reflects industry practice, and the main thrust is around transparency and disclosure. The impact may be more akin to the ILPA reporting template, effectively working to standardize disclosure to enable better assessment by LPs rather than bring about any commercial change to what is an increasingly popular part of the market.
