The rise of continuation funds in private equity — explained

Oxford Uni student Yoshinori Maejima introduces the concept of continuation funds and explains their impact on law firms

What are continuation funds in private equity?

Continuation funds are a type of exit plan in the private equity secondary transactions market. Private equity firms buy and manage unlisted, underperforming companies to increase their profitability, to be sold off or listed on the stock exchange for a profit. The primary and secondary markets differ in significant ways. Whereas the primary transactions market consists of Limited Partnership (LP) investors (investors who invest into private equity funds) investing directly into the fund and buying an interest from the General Partner (professionals responsible for managing the investment fund), the secondary transactions market consists of investors buying and selling existing/pre-owned investments in private equity funds with other investors. Continuation funds have formed nearly 50% of secondary transactions since 2021, and are a crucial form of secondary transactions in the ever-expanding private equity market.

Continuation funds allow for the fund manager to distribute the revenue from the existing investment to its current investors while also allowing for a continuation in ownership under its current management. In short, continuation funds allow fund managers to have continued ownership of existing investments while also providing liquidity to investors.

What are its benefits, and why is it on the rise now?

Asset management company Schroders notes that continuation funds have become a popular exit option in the secondary market due to the increased market volatility and geopolitical uncertainties. Such uncertainties discourage traditional exit options in private equity, namely IPO (Initial Public Offering, or listing on the stock exchange) and mergers and acquisitions. Continuation funds thus provide existing investors with more options for liquidity.

Additionally, continuation funds allow for long-term strategies to be implemented in existing investments. This allows for the growth of high-quality, high-potential companies to realise their full market potential. Additionally, because continuation funds allow for the continued ownership of the portfolio companies by the same General Partner, they can employ existing, experienced management teams to continue developing the company’s long-term strategy.

What are the risks?

However, continuation funds carry significant legal risks. Firstly, because the same private equity firm acts as the buyer (as the continuation fund) and the seller (as the existing fund), it creates a potential conflict of interest. Private equity firms must make sure that a fair price is given to the portfolio companies being sold to the continuation fund from the existing fund, in order not to favour one group of LP investors over another. To mitigate this issue, EQT, a Swedish global investment firm, notes that the presence of a neutral, third-party advisor who ensures the fairness of the prices for which the assets are being sold from the existing fund to the continuation fund is crucial in resolving any conflicts of interest that may exist.

Additionally, ensuring that the interests of the General Partner and the LP investors of the funds are aligned is crucial. This is important as the General Partner must work to maximise the value of investments made by the LP investors. The Institutional Limited Partners Association (ILPA) states that the General Partners are usually expected to contribute 100% of their carried interest earnings from the existing fund to the continuation fund to ensure the alignment of interests between the General Partner and the LP investors.

How does this affect law firms?

The rise of continuation funds affects law firms in significant ways. Firstly, it increases the volume of transactions, thus creating more work for transactional and advisory lawyers. The work of these lawyers is crucial in making sure that these transactions are as efficient as possible from a business and tax point of view while complying with all legal requirements pertaining to private equity in all relevant jurisdictions. The work of advisory and regulatory lawyers is made particularly important in light of the increased regulatory scrutiny into GP-led secondary transactions since 2023. Orrick, a global law firm, notes that regulators, particularly those in the US, scrutinise these transactions to ensure that the interests of the LP investors are not being compromised and that the third-party advisors to these transactions do not have existing relationships with those involved in the transaction, which could create conflicts of interest.

Conclusion

In conclusion, continuation funds are a necessary and crucial exit option at a time of heightened geopolitical and economic uncertainty. They serve two crucial purposes, as they allow for the continued ownership of strategically important private equity investments while also providing liquidity to LP investors. However, they carry significant legal risks, with the potential conflict of interest being the most significant. Law firms have a significant role to play in navigating such complex transactions.

Yoshinori Maejima is an undergraduate student reading history and politics at the University of Oxford.

The Legal Cheek Journal is sponsored by LPC Law.