Continuation Fund

Key takeaways

• Continuation funds allow GPs to extend ownership of select assets beyond a fund's typical lifespan, providing more time to maximise value.
• These vehicles offer liquidity options to existing LPs while allowing interested investors to maintain exposure to promising assets.
• Continuation funds have become a significant component of the private equity secondary market, representing billions in transaction volume annually.
• They require careful structuring and alignment of interests between GPs, existing LPs, and new investors to be successful.
• Regulatory scrutiny and best practices for continuation funds continue to evolve as they become more prevalent in the industry.

What is a continuation fund?

Definition and purpose

A continuation fund is a private equity vehicle designed to extend the holding period of one or more assets from an existing fund that has reached or is approaching the end of its lifecycle. The primary purpose of a continuation fund is to allow fund managers (general partners or GPs) to maintain control over promising assets while providing liquidity options to existing investors (limited partners or LPs) who may wish to exit.

Historical context and evolution of continuation funds

Continuation funds emerged in the aftermath of the global financial crisis when many private equity funds found themselves holding assets longer than anticipated due to the challenging exit environment. Initially viewed as a niche solution, they have since evolved into a mainstream feature of the broader private equity secondary market.

The concept gained traction as both GPs and LPs recognised the potential benefits: GPs could continue to manage and add value to high-performing assets that needed more time to reach their full value potential, while LPs gained the optionality to either cash out or reinvest in the new vehicle.

Growth trends and market size

The use of continuation funds has grown significantly over the past decade.

• The total volume of GP-led secondary transactions, which primarily constitute continuation funds, grew from just $9 billion in 2015 to over $51 billion in 2023.¹
• Continuation funds now represent a substantial portion of the overall secondary market. GP-leds as a whole accounted for 45% of the market in 2023, while continuation funds made up 88% of this transaction value.²
• The COVID-19 pandemic accelerated the adoption of continuation funds. The market volatility and economic uncertainty during this period made it difficult to achieve favourable exits through traditional means. Continuation funds allowed GPs to hold onto high-quality assets longer, betting on a post-pandemic recovery to maximise value.

Mechanics of continuation funds

Detailed explanation of how continuation funds operate

1. Identification of assets: The GP identifies one or more assets from an existing fund that they believe have further value creation potential.
2. Structuring: A new vehicle, the continuation fund, is set up to purchase these assets from the existing fund.
3. Pricing and valuation: An independent valuation is typically conducted to determine a fair price for the assets.
4. LP options: Existing LPs are given the choice to:
   1. Sell their pro-rata share of the assets and exit
   2. Roll their interest into the new continuation fund
   3. A combination of both‍
5. New capital: The continuation fund raises capital from new investors, typically dedicated secondary funds, to purchase the assets and potentially provide follow-on capital to support the growth of the portfolio companies.‍
6. Transaction closure: The assets are transferred to the new continuation fund, with proceeds distributed to selling LPs.‍
7. Ongoing management: The GP continues to manage the assets in the new vehicle, typically with a reset of the fund’s economics to better align the interests of the GP and LPs. For instance, carried interest is usually calculated from the current net asset value (NAV) at the time the continuation fund is established, not from the initial investment cost, thereby incentivising the GP to generate returns above the new NAV.

Types of continuation vehicles and how they compare

Single asset continuation funds

• Focus on a single portfolio company
• Often used for "crown jewel" assets with significant additional upside potential
• Allows for tailored strategies and focused value creation plans
• Generally easier to price and structure due to focus on a single asset

Multi-asset continuation funds

• Include multiple assets from the original fund
• Provide diversification benefits for incoming investors, smoothing returns
• May be more complex to structure and price due to multiple assets
• Can allow for cross-collateralisation and risk balancing across assets

Continuation funds: pros and cons

Pros

1. Extended value creation: Allows GPs more time to maximise the value of high-potential assets.
2. Liquidity option: Provides an exit opportunity for LPs who desire liquidity.
3. Alignment of interests: GPs can retain control of assets they know well and believe in.
4. Flexible capital: Can provide additional capital for growth or add-on acquisitions.
5. Diversification for new investors: Offers access to mature, de-risked assets for new LPs.

Cons

1. Potential conflicts of interest: GPs must balance interests of existing and new investors.
2. Complexity: Structuring and executing continuation funds can be complex and time-consuming.
3. Pricing challenges: Determining a fair price for assets can be difficult and contentious.
4. Regulatory scrutiny: Increasing regulatory focus on transparency and fairness in these transactions.
5. Performance pressure: High expectations for continued value creation in extended holding period.

Continuation funds in private equity

Role and significance within the broader private equity sector

Continuation funds have become an integral part of the private equity industry, offering several benefits:

1. Portfolio management flexibility: Allows GPs to optimise exit timing and strategy for individual assets.
2. Expanded investor base: Attracts new investors to mature private equity assets.
3. Alignment with longer-term value creation: Supports investment strategies that may require more time to fully realise their potential.
4. Liquidity solution: Provides a mechanism for LPs to achieve liquidity in a controlled manner.
5. Market adaptation: Helps private equity adapt to changing market conditions and longer hold periods for certain assets.

Comparison with other private equity fund structures

Continuation funds differ from traditional private equity structures in several ways:

1. Lifecycle: Unlike standard 10-year funds, continuation funds are typically structured with a 3-5 year investment period.
2. Asset maturity: Focus on mature assets rather than new investments.
3. Investor composition: Often involve a mix of existing and new investors.
4. Fee structures: May have different management fee and carried interest arrangements compared to traditional funds.
5. Exit focus: Primarily focused on optimising exit for specific assets rather than building a diversified portfolio.

Continuation funds have quickly become a mainstay of a growing PE secondary market. Their increasing prevalence is part of a broader trend towards increased flexibility and customisation in private equity that both meets the liquidity needs of investors allocated to an inherently illiquid asset class, while providing a runway for GPs to deliver greater value creation.

However, the success of these funds hinges on meticulous structuring, transparent communication and robust deal processes to manage potential conflicts of interest. This is essential to maintaining investor confidence and ensuring that both new and existing stakeholders are treated equitably.

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