Travers Smith's Alternative Insights: The benefits of a well-structured continuation fund

A regular briefing for the alternative asset management industry.

Although some recent press commentary may suggest otherwise, the rise in so-called "continuation funds" (or, as the FT has labelled them, "sell-to-yourself" deals) is a healthy sign of a maturing market.  Of course, there are issues that need to be carefully navigated – not least, the inevitable conflicts that arise – but these are familiar and manageable issues.  As we discussed at our inaugural Alternative Insights summit last week, an appropriately structured deal can lead to a win-win-win for the investors, the fund manager and the target asset(s).

Much of the private capital universe focuses on relatively long-term investments in illiquid assets.  For investors who do not need short-term, unplanned liquidity – which includes most institutional investors – the most efficient way to invest in such assets is through closed-ended pooled investment vehicles.  As the private markets have grown, a huge number of assets are now held in that way, and – as European policymakers have acknowledged – that brings significant advantages for the real economy, as well as for institutional investors and their ultimate beneficiaries.

But investors need liquidity at some point, and one way to achieve that is for the fund to have a fixed term – in practice usually around 10 years.  That means that, at some point, the fund will have deployed most of its capital, leaving the assets held by the fund with limited access to follow-on funding and the fund manager, or GP, with only a few years left to generate value and sell its investments.  The fund is effectively a forced seller at a somewhat arbitrary point in time.

For most investments, that does not matter.  The business model of private equity assumes that significant changes can be made over the course of the expected holding period, and the asset made ready for sale within the fixed life of the fund.  But when that is not the case, and an asset would benefit from more time and more capital, the secondary market allows a fund manager to offer a liquidity option – effectively the right for investors to receive cash within the existing fund term, or to retain exposure to the asset through a longer-dated vehicle that has greater access to follow-on capital.

The first priority for a GP looking at a continuation fund deal is to explain why it considers that to be the best option for investors. In many cases, a deal can fail at this first hurdle. But, often, the GP will have a compelling edge over the market.

Although not the only solution, in many cases this is the structure that allows the most flexibility for the fund manager and the investors, with the least disruption to the underlying business.  

It is, of course, critical to ensure that all investors are properly protected. There are robust and tried-and-tested processes, underpinned by existing and forthcoming LP-side guidance, to ensure the conflicts are identified and transparently managed and, in particular, that there is an objective price discovery mechanism.  Fund managers have contractual, fiduciary and regulatory responsibilities and are sharply attuned to the issue, while investors and regulators (most recently, the US SEC) have been clear that these transactions will be closely watched.

The first priority for a GP looking at a continuation fund deal is to explain why it considers that to be the best option for investors.  In many cases, a deal can fail at this first hurdle. But, often, the GP will have a compelling edge over the market. For example, the GP may know the asset and its sector better than anyone else (reducing buyside risk); may have a well-established and productive relationship with a management team that wants to avoid the business disruption of an M&A deal; or have bolt-on acquisitions in the pipeline that will generate significant further upside but require additional equity financing. These and other factors may drive up the price – to the benefit of exiting LPs.

But having established that it may be in a position to pay more than other prospective buyers, the GP needs to demonstrate that it can structure and execute a transaction that works for all parties. In almost all instances, this will involve an intermediated auction involving the secondary market and, increasingly, this now involves consideration of third-party private equity sponsors and even trader buyers who may be interested in a minority sale (with the continuation fund's participation set with reference to the price established in this way). In most cases, the Limited Partner Advisory Committee (LPAC), who will have to waive conflicts in respect of the deal, will insist on a third-party fairness opinion. If they do not, it is generally because there is an alternative, more robust, way to benchmark the price.

Next, the GP should focus on future economics to build strong alignment of interest.  Typically, cash received by the fund manager's team on the sale – carried interest and "GP-commitment" – is re-invested. That helps to demonstrate to a secondary buyer that the fund manager believes in the upside, helping to drive up the price – again, for the benefit of selling investors. 

It is also important that the terms of the continuation fund are not price dilutive for the buyer: typically, this means a low management fee and, perhaps, a higher hurdle, or a lower carried interest rate which ratchets up if there is outperformance. The standard "2 and 20" model is not in play here.  The LPs who choose to roll over may take significant comfort from the fact that a highly sophisticated secondary fund is willing to commit alongside on similar (or sometimes worse) terms.

Getting ahead of the process is crucial.  Since conflict waivers will be required from the LPAC, their early involvement is advisable, with regular updates as the deal progresses.  LPs will also need enough time to properly consider the options, usually at least a month.  Documentation should carefully, fully and fairly analyse and disclose all conflicts of interests and describe how they have been managed. 

Single asset GP-led deals are not easy to do, and investors and regulators rightly expect an open and fair process.  But, as long as some widely accepted principles are applied, there is no reason to inhibit deals from which everyone – including the underlying operating business itself – can do well.

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