In recent years, continuation funds have rapidly grown in popularity as fund managers and investors alike seek to extract value from existing assets and take advantage of available dry powder. This has boosted the secondaries market as GPs roll investments into new funds and seek to hold on to assets for longer periods of time.

The slow M&A and IPO markets of the pandemic sent GPs searching for alternative liquidity opportunities as vehicles came to the end of their life cycle, but often still had value to extract. "Continuation funds" - GP-led secondary vehicles often structured as a new fund set up to take on assets of a fund nearing the end of its lifecycle - have become a popular solution. No longer viewed as "zombie" funds vehicles for assets that were in distress, struggling to make an exit, or unable to return capital continuation funds are now seen as a way to continue to extract value from "trophy" assets when there is still more "juice to squeeze". A continuation fund offers flexibility to hold an asset when there is more value to be extracted or the timing is not right for an exit (given the macroeconomic or political climate), and can be seen as lower risk than traditional funds as GPs are already familiar with the asset.

Besides the benefits for the GPs and LPs, portfolio companies are also often times keen to be brought into a continuation fund, as the management team would typically cash in at least part of their exit-linked incentives on such a transaction, and would do that without the hassle and uncertainties of a full blown change of control/changing the GP team that they report to.

The US has seen rapid growth in GP-led transactions from representing less than 5% of the secondary market volume in 2013 to representing almost 50% in 20201. While not as rapid as the US, Asia and Europe have also seen impressive growth in continuation funds. We expect to see continued growth in this type of transactions, especially as economic uncertainty creates disparity between buyer and seller expectations.

Continuation funds are created through bespoke transactions, and the structure is unique to each deal. Often, a new vehicle is created into which selected assets are rolled. Investors of the existing fund have the option to exit or continue with the new fund. New investors are brought in as necessary to take out the existing LP stakes and/or provide new, primary cash capital depending on the follow-on capital requirements of the subject portfolio.

As the deal is structured, the GP must also balance the competing interests of legacy LPs and new LPs. Often the terms of the deal are determined by the terms and conditions of the existing fund, which may favor legacy investors. Creating a new fund presents an opportunity to realign incentives that may have shifted over the lifespan of the existing fund. Inherent in the structure of a continuation fund are the conflicts of interest affecting the GP, as the GP is essentially controlling the existing fund (seller) as well as the new fund (buyer). At a very basic level, investors cashing out want to see a high price/valuation to realize a return on their investment. Those buying in seek a low price, to better realize future value. The GP must set a price that fulfils the fiduciary duty to current investors, while still being balanced and bringing in new investments to consummate a transaction. As continuation funds continue to gain popularity, best practices have emerged to mitigate conflicts of interest and assuage warry investors. To be effective, these practices must be robust, fair and transparent, and include: Engage LPs Early in the Deal. Communicate with existing LPs as to why this is the best/preferred option and be clear. Maintain transparency regarding the diligence performed, and the economics proposed. As much as possible, exchange information symmetrically. Carefully Consider Fees/Transaction Costs. Be conscious of how fees and transaction costs will impact both the GP and outgoing and incoming investors. What will be rolled over into the new fund? What will be extracted by the GP? GPs are often expected to make a cash commitment to the new fund. How will that commitment be structured?

Procure a Fairness Opinion or Independent Valuation. Obtaining a fairness opinion or independent valuation can increase investor confidence in this type of transaction. In early 2022, the SEC proposed new rules under the Investment Advisors Act of 1940 intended to increase transparency to investors. Worth noting is a proposed requirement for an adviser to obtain a fairness opinion from an independent opinion provider for certain adviser-led secondary transactions. The proposed rule states:

"We propose to require an adviser to obtain a fairness opinion in connection with certain adviser-led secondary transactions where an adviser offers fund investors the option to sell their interests in the private fund, or to exchange them for new interests in another vehicle advised by the adviser"2.

Per the SEC proposal, the fairness opinion would in all likelihood be required even in circumstances where the GP has conducted a competitive sales process. This requirement, as proposed, would not apply to advisers that are not required to register as investment advisers with the SEC (such as state-registered advisers and exempt reporting advisers). The record-keeping obligations to investment advisors are also proposed to be correspondingly enhanced to evidence compliance with the obligation of providing a fairness opinion and of ensuring the independence of the opinion provider (by disclosing to LPs any material business relationships the adviser or any of its related persons has, or has had within the past two years, with the independent opinion provider), and thus allow the SEC to exercise effective oversight and controls over such new requirements. The proposal goes on to consider an alternative option for advisers to acquire an independent valuation.

"The Commission could consider requiring advisers to obtain a third party valuation in connection with certain adviser-led secondary transactions, instead of a fairness opinion. We believe that these third party valuations would likely involve more diligence of the proposed transaction than the reviews conducted in connection with obtaining a fairness opinion, and therefore, requiring these valuations could provide even greater assurances to investors that the terms of the transaction are fair to their interests. However, we believe that obtaining a third-party valuation would likely be significantly more costly to obtain. If these costs could be passed on to participants in these transactions, it could make them less attractive to investors as a means to obtain liquidity".3

Many GPs are already in the habit of obtaining fairness opinions in GP-led secondary transactions, even in the absence of a legal requirement, as a matter of best practice and good corporate governance, for boosting investor confidence and/or as a way of discharging their own fiduciary duties. Indeed, ILPA, in its guidelines "GP-led Secondary Fund Restructurings - Considerations for Limited and General Partners", recommends to LPs to obtain fairness opinions in certain instances, particularly in complex restructurings. Continuation funds are here to stay, and are embraced beyond the PE world, by venture capital and growth funds. As valuations are on a downwards trajectory given macro headwinds (accelerating inflation and interest rates, lower stock prices, energy crisis etc.), continuation funds are a strategy worth considering for GPs and LPs alike. They provide options and valuable flexibility in a complex and uncertain environment.

When it comes to structuring and implementing a continuation fund, the importance of experienced advisers on both the GP and the LP side, able to navigate the pitfalls and intricacies of such complex and bespoke transactions, cannot be overemphasized.