ILPA issues Guidance on Continuation Funds

Given the rising prominence of continuation funds in the private equity industry, the Institutional Limited Partners Association (ILPA) recently published guidance setting out the suggested parameters for a well-run continuation fund transaction (the Guidance). In this article, we discuss the key takeaways from the Guidance and some of our related observations.

What is a continuation fund?

In recent years, continuation funds have been increasingly prominent in the private equity space. A lot of general partners (GPs) have opted to move selected investments into a continuation vehicle, offering limited partners (LPs) the option to (i) roll into the new vehicle, (ii) sell their interests or (iii) a combination of both.

Continuation funds when properly utilized can offer advantages for multiple stakeholders in the fund. For example, these funds can give investors who transition into the new vehicle and sponsors the option to hold on to investments that are performing well even after the term of the existing fund, while also supplying liquidity to LPs in the existing fund.

Having said that, continuation funds are also riddled with certain inherent difficulties, such as their conflicted nature (as the GP sits on both the buy and sell side of the transaction), their complexity and the speed at which these transactions are run.

In light of the above, in May 2023, the ILPA (which is a global organisation that advances interests of private equity investors) published Guidance on how continuation funds can be structured so as to reduce strain on the alignment of interest between LPs and GPs.

Given the bespoke nature of continuation fund transactions, the ILPA noted that the recommendations in the Guidance may not be appropriate or applicable to every circumstance. Nonetheless, the Guidance is intended to provide general parameters for well-run continuation fund transactions and cultivate informed decision-making by LPs and more aligned outcomes overall.

Stages of a Continuation Fund

The Guidance introduced 2 guiding principles for continuation fund transactions:

1. Continuation fund transactions should maximize value for existing LPs.
2. Rolling LPs should be no worse off than if the continuation fund transaction had not occurred.

To that end, the ILPA considers that a well-run continuation fund consists of the following key stages:

1. GP presents rationale for selling the selected assets to a continuation vehicle to the Limited Partner Advisory Committee (LPAC); and shares the rationale with all LPs.
2. GP selects and engages an advisor to structure the process, solicit bids and guide the transfer of fund assets.
3. LPAC shall review the structure of the process and any conflicts related to the proposed transaction.
4. LPAC shall vote on whether or not to waive the conflicts associated with the transaction. LPAC should be given 10 business days to review the transaction and the opportunity for an in camera session (i.e. closed meeting) prior to the vote.
5. GP solicit bids and notifies LPs. Due diligence will be conducted by potential investors. Portfolio company disclosures shall be provided to acquirers and made accessible to LPs.
6. Confidential disclosure documents shall be circulated to all LPs outlining the final proposed terms and conditions of the transaction, indication of new terms that differ from the original LPA, amendments to governing documents and framework for allocating transaction-related expenses.
7. LPs shall be afforded sufficient time (i.e. no less than 30 calendar days/20 business days) to evaluate the GP proposal and elect to: (a) roll their interests on a pro-rata basis into the new entity, (b) sell their interests to the acquirer on the terms offered, (c) roll their LP interests into a continuation vehicle and purchase more interests or (d) some combination thereof.
8. In cases where LP is unable to respond to an election within sufficient time, such LP should be treated as electing to liquidate its interests. LPs should never be forced to roll their interests into a new vehicle.

Managing Conflicts Related to the Transaction

Under the Guidance, any conflicts related to the process and final economics of the transaction (including cases where there is economic incentive accruing to the GP) should be identified, mitigated where possible and approved by the LPAC.

GPs and LPs should avoid having terms in the LPA that seek to ‘pre-clear’ conflicts associated with continuation fund transactions at the launch of the original fund. All conflicts should be mitigated and cleared when they arise. Indeed, although we do see a rising prevalence of these ‘pre-clearance’ provisions in the fund documents in the market, in our experience these provisions are often pushed back by LPs. In practice, we see that LPs would normally appreciate a continuous dialogue between the GP and LPs with respect to the structuring of continuous fund transactions so as to ensure that the interests of the GP and LPs are aligned.

The Guidance further recommends that to the extent that there are any differences in the terms of the continuation vehicle as compared to those of the existing fund, those terms and the basis for the differences should be fully disclosed.

Disclosures to the LPAC – Solicitation Process and Bids

LPAC members should be provided information to assess whether the continuation fund transaction was structured appropriately to ensure a fair price was obtained in relation to conflict of interest waivers. The Guidance recommends that a fairness opinion from an independent financial advisor may be helpful in this context. In our view, it is common market practice that such a fairness opinion from an independent advisor is obtained for continuation fund transactions.

The following are some of the recommended disclosures in respect of the bidding process as set out in the Guidance:

• Description of the process for soliciting bids from potential acquirers.
• Overview of the bids received (including the number of bids and pricing).
• Discounted pricing or more favorable economics for any potential acquirers relative to rolling LPs, including any special terms such as stapled financing.
• New capital provided by existing LPs, if any.
• The participation by any LPAC members as acquirers, if any.
• Management fee (both the percentage paid and actual dollars) and carried interest percentage for LPs in the continuation fund.
• The percentage of crystallized carry being rolled into the continuation vehicle, and the rationale behind that number.
• Any other meaningful changes in terms versus the original fund.

Disclosures to LPs and Parity of Information Provided

To ensure that LPs who are not represented in the LPAC have access to relevant information, the Guidance recommends that the GP should provide LPs (beyond the LPAC) disclosures required to allow sufficient time to review the continuation fund transaction. GPs should endeavor to achieve parity in the information provided to the acquirer and to the LPs in the fund.

Once the final terms of the proposed transaction have been set, LPs should have access to the same level of information about the process as LPAC members (i.e. information in relation to the bids, whether any LPAC members participated and were considered as finalists in the bidding process and the justification as to why the “winning bid” was selected).

The Guidance prescribes the following recommended disclosures that the GP shall provide to the LPs in respect of the selected assets, in order to carry out diligence on the assets included in the continuation fund:

• The GP’s investment memo and the returns to date on each selected asset.
• Asset-specific information required for due diligence related to material risks.
• Detailed information on the basis for the assumed price and multiple of the assets.
• The GP’s view on potential returns at exit for each selected asset.
• The performance of any continuation fund the GP currently manages or has managed in the past. Note that the Guidance does not differentiate which types of continuation funds or underlying assets should be disclosed. In practice, we consider that it might be more relevant for LPs to review performance of any continuation fund that the GP has managed or currently manages that concerns the same type of assets as the present proposed continuation fund transaction (e.g. real estate, technology companies, healthcare companies etc).

“Status Quo” Option

The Guidance provides that LPs must be provided the “status quo” option to participate in the new continuation vehicle with no change in economic terms. This means that:

1. There should be no increase in the management fee rate.
2. There should be no change in the management fee base.
3. There should be no increase to the carried interest rate, decrease to the preferred return hurdle or other GP-favorable changes to the distribution waterfall.
4. There should be no crystallization of carried interest for rolling investors.

LPs rolling into the new vehicle should not be disadvantaged as compared to their status prior to or absent the continuation fund transaction.

Advisors to the Transaction

The Guidance recommends that an experienced advisor be engaged by the GP to solicit bids. It is further recommended that the LPAC should review the GP’s selection of the advisor and the advisor’s engagement to ensure that the compensation is fair and customary and structured in a way that maximizes value for existing investors.

Separate from the GP-selected advisor above, the Guidance also recommends that the LPAC should have the right to avail itself of an experienced independent legal and specialist advisor, to offer counsel on the structure of the process, the transaction terms and valuation and waiver of any conflicts. In our experience, it is common market practice for LPs to request for an express right to counsel to be set out in the original fund documents, and such legal expense will normally be deemed as a fund expense.

Recommendations for LPs

In addition to the above, the Guidance sets out the following recommendations to the LPs in respect of continuation fund transactions:

• LPs should establish internal protocols to respond to these transactions (e.g. approval processes and underwriting processes). We agree with this recommendation on the basis that continuation fund transactions are often fast-paced and requires prompt evaluation by the LPs. It would be useful to have these internal protocols in place so that LPs can react quickly in the event that they are asked to evaluate a continuation fund transaction.
• When transactions arise, LPs should work with GPs to set timing expectations around reviews, negotiations and approvals.
• When transactions arise, LPs should request that GPs provide all materials necessary to be fully informed and that there should be a symmetry of information between existing LPs and prospective new buyers.

Concluding Remarks

Through the issuance of the Guidance, the ILPA expects to promote greater transparency and consistency to maximize the efficiency and quality of execution of continuation funds. While we will wait to see how the recommendations set out in the Guidance will be implemented in practice, it serves as a useful benchmark for GPs, LPs and relevant stakeholders when structuring and participating in continuation funds transactions. If you are interested in any of the above issues or would like to set up a continuation fund, please contact Luke Gannon (Head of Funds and Investment Management, Asia) and we are happy to assist.

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