15 minute read | September.28.2023
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 transactions are distinct from traditional secondary deals.
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:
Continuation funds also allow the GP to:
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:
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.
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.
In 2016, GP-led transactions represented 24% of the secondaries market; however, by 2021, GP-led transactions represented 52% of all secondary transaction volume. 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.
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:
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:
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.
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:
GPs can also address potential issues with rolling LPs by, among other things, ensuring that there is no:
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:
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.
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:
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.
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.
 Evercore, 2022 Secondary Market Synopsis.