Continuation Fund

Continuation Fund as a Source of Alternative Liquidity

Due to the changed market environment (changes in interest rates, reduced liquidity, uncertainties in asset valuation), funds investing in illiquid assets (primarily private equity and venture capital, as well as real estate) have found it increasingly difficult to find attractive exit opportunities. This, in turn, makes it harder to establish new funds, as investors lack sufficient resources (free allocation) to invest in such asset classes. At the same time, funds are approaching their maturity, and investors typically expect distributions depending on their own investment strategies and liquidity needs.

In such a market environment, fund managers are seeking additional ways to create liquidity options for investors. Whereas fund restructuring previously carried a negative connotation (dealing with poor-quality assets), the creation of continuation funds as led by the fund manager is aimed at offering a new investment opportunity based on existing high-quality assets that are believed to have further growth potential. This is attractive to new investors, as they have better visibility into the assets and their growth outlook as compared to providing a mandate to the manager for a new “blind-pool” of investments. Existing investors whose original investment thesis is satisfied by the returns achieved, or whose strategy does not allow for a longer investment horizon, receive an exit opportunity. Existing investors who wish to participate in the continued growth of selected assets are given the opportunity to participate in the continuation fund.

The increasing prevalence of continuation funds also has secondary effects on the private equity transaction market. If a sale to another private equity fund is often a viable exit route for a fund, then the creation of continuation funds reduces the supply of high-quality assets on the market. This may affect managers’ ability to deploy capital into quality assets and force them to find new investment opportunities, including exploring cooperation with other private-equity sponsors in the establishment of continuation funds.

Focus on High-Quality Assets and Their Valuation

In practice, continuation funds may involve either a single asset, or multiple companies, assets, or investments. A single-asset structure allows focus on the development of a specific company or asset or, more narrowly, taking a specific sector or thematic risk. Multi-asset continuation funds allow for better risk diversification. Naturally, asset quality is crucial. Unlike distressed transactions where assets are sold below market price, continuation fund transactions assume sale at fair market value. Therefore, the future return potential of assets is decisive.

Because a sale of assets to an affiliated party (another fund managed by the same manager) inherently involves a conflict of interest, fund agreements impose investor-protective rules for such transactions. Typically, approval from investors or an investor committee (LPAC) is required. To protect existing investors, asset disposals should occur at fair value validated by an independent party. The U.S. Securities and Exchange Commission (SEC) has imposed additional regulatory requirements to address inherent conflicts of interest in creating continuation funds. According to these rules, the manager must obtain an independent advisor’s valuation opinion or fairness opinion for the transaction, which must be made available to investors—together with other key transaction information, including potential conflicts—before the transaction is completed.

Multiple Parties with Different Interests

Several parties are involved in the creation of a continuation fund, each with specific interests that must be considered:

Fund Manager:
Successful creation of a continuation fund requires that the manager has demonstrated strong performance in managing the existing assets and has the full trust of investors to continue doing so. The manager knows the asset well and has a long-term investment thesis for value creation. Given the need to ensure liquidity for investors at fund maturity, the manager seeks to maximize asset value and thus their own compensation.

Existing Investors:
Depending on their investment strategies and liquidity profiles, investors’ interests are often different. Some, satisfied with the results achieved, wish to exit. Others with a longer investment horizon may wish to continue holding the asset and maximize its growth potential, either under existing terms or under the continuation fund’s new terms.

New Investors:
Investors providing liquidity are looking for attractive opportunities on favourable terms. Unlike typical blind-pool funds, continuation fund investors have significantly better visibility into the investment potential. The manager’s background and track record in value creation are also important. The transaction terms are negotiated primarily with the anchor investor.

Advisors:
Larger markets have advisors specialized in continuation fund transactions. Such requisite competence combines both M&A advisory and capital-raising expertise. Final commercial terms may be determined through an auction or book-building process ranking potential investors by price and commitment size. Fair allocation of transaction costs is important.

Valuers:
Approval of a related-party transaction by existing investors for creating a continuation fund generally requires assurance that the assets are transferred at fair price. Independent appraisers should therefore validate the transaction price.

Regulators:
The scope of regulatory oversight depends on jurisdiction and manager status. Regulators focus particularly on conflict-of-interest management and ensuring fair treatment of investors.

Commercial Terms of a Continuation Fund

A continuation fund allows the manager to reset the fund economics specifically for the selected assets. As with any fund, this requires negotiations with (cornerstone) investors to align interests. Key elements include the manager’s co-investment, carried interest, and management fees.

Typically, investors expect a higher manager co-investment in continuation funds. If the manager earns carried interest from the asset sale, investors usually expect this carried interest to be rolled into the continuation fund. This increases the manager’s exposure to asset growth. Therefore, the continuation fund’s investment thesis must be sufficiently attractive and credible, and the manager must be ready to commit significant capital.

Carried interest (performance fee) is another growth-based compensation element. While standard private equity practice is 20% carried interest, continuation fund market practice favours greater differentiation—carried interest becomes tiered and linked to the actual success of the investment thesis. Common metrics include IRR and money-multiple criteria (sometimes mixed). Carried interest typically falls within 10–20%.

Management fees in continuation funds should be less important as a driver for managers. As management fee during the value-creation period is based on acquisition cost, the fee in continuation fund is generally lower than in a blind-pool fund (where the market standard is 2% annually). The reason is simple: managers find it difficult to convince investors to pay a higher cumulative management fee than what the manager has already received for managing the same asset. Since the asset value at the time of forming the continuation fund is typically much higher than original acquisition cost, a lower management-fee rate is agreed.

Ultimately, continuation fund economics (including cost allocation) depend on detailed negotiations with investors, as well as transaction advisor’s recommendations. Expected returns are modelled through the continuation fund’s distribution waterfall.

As continuation funds become an increasingly important liquidity tool in the market, fund managers forming new private equity funds should consider the possibility of creating a continuation fund and incorporate this into their blind-pool fund-term negotiations.