Continuation funds

What Are Continuation Funds?

Continuation funds are specialized private equity vehicles established by a general partner (GP) to acquire one or more assets from an existing fund that is nearing the end of its fund lifecycle. These funds fall under the broader category of private equity, specifically within the secondary market, serving as a mechanism for GPs to extend their ownership and management of particular portfolio companies beyond the typical fund term. The primary purpose of a continuation fund is to allow the GP to continue to nurture high-performing or "trophy" assets that require more time to reach their full value potential, rather than being forced to sell them in a potentially unfavorable market.

History and Origin

The concept of continuation funds emerged more prominently in the aftermath of the 2008 global financial crisis. At that time, many private equity funds found themselves holding assets longer than anticipated due to challenging exit strategy environments. Initially, these vehicles were often referred to as "restructuring funds" and were primarily used for distressed assets¹⁴. However, by around 2015, general partners recognized that these structures could serve as valuable portfolio management tools not just for struggling assets, but also for their top-performing investments¹³. This shift in perception led to the evolution of continuation funds into a mainstream feature of the broader private equity secondary market¹². The growth of the secondary market itself, which provides liquidity for an otherwise illiquid asset class, laid the groundwork for the increased adoption of GP-led transactions like continuation funds¹¹. The volume of GP-led secondary transactions, predominantly comprising continuation funds, has grown significantly, indicating their increasing prevalence in the private equity landscape¹⁰.

Key Takeaways

• Continuation funds enable general partners to extend their holding period of specific portfolio assets beyond a traditional fund's term.
• They provide existing limited partners with the option to either cash out their investment or roll their interest into the new continuation fund.
• These funds are a significant component of the private equity secondary market, offering liquidity solutions and flexibility for both GPs and LPs.
• Continuation funds can help optimize return on investment for high-performing assets that need more time to mature.

Interpreting Continuation Funds

Continuation funds are interpreted as a strategic tool within private equity to manage the investment horizon of specific assets. When a general partner establishes a continuation fund, it signals their strong conviction in the future growth potential of the underlying asset(s). For existing limited partners, the decision to cash out or roll over their stake is a critical one, often based on their own portfolio strategy, desire for liquidity, and assessment of the asset's remaining upside. The transaction allows new investors to gain exposure to more mature assets with established performance, potentially offering a quicker path to returns compared to traditional blind-pool fund investments.

Hypothetical Example

Consider a private equity Fund A, launched in 2015 with a 10-year term, holding five portfolio companies. By 2025, four companies have been successfully exited, but Company X, a software firm, is experiencing rapid growth and is projected to increase its asset valuation significantly over the next three to five years. Instead of being forced to sell Company X as Fund A winds down, the general partner of Fund A decides to create a continuation fund.

The GP engages an independent third-party valuation firm to assess Company X, determining its current net asset value. Fund A's limited partners are then given the option: they can sell their pro-rata share of Company X to the new continuation fund and receive cash, or they can roll their interest into the continuation fund, maintaining their exposure to Company X's future growth. For instance, an LP who invested $10 million in Fund A might have a $2 million share attributable to Company X. They could choose to receive $2 million in cash or transfer their $2 million interest into the newly formed continuation fund, effectively reinvesting. The continuation fund might also raise additional capital from new limited partners interested in Company X specifically.

Practical Applications

Continuation funds are primarily observed in the private equity sector, serving as a flexible mechanism for managing portfolio assets. They allow GPs to bypass the rigid timelines of traditional fund structures, especially when market conditions are not conducive to a favorable sale of a high-quality asset⁹. This flexibility is critical for assets that require extended development periods or those where maximizing value necessitates a longer hold. They also provide a structured way for existing limited partners to realize liquidity from their investments without a forced sale of the underlying asset⁸. The increasing use of continuation funds reflects a broader trend in private markets towards more tailored portfolio management and liquidity solutions for investors in illiquid asset classes⁷. The private equity secondary market, in which continuation funds play a growing role, is poised for continued expansion, with market participants estimating substantial annual transaction volumes⁶. According to one report, the private equity secondary market was poised for another record year in late 2023, driven by a growing appetite for GP-led deals, including continuation funds⁵.

Limitations and Criticisms

Despite their advantages, continuation funds face certain limitations and criticisms, primarily concerning potential conflicts of interest for the general partner. Since the same GP often manages both the selling fund and the buying continuation fund, there can be concerns about the valuation of the assets being transferred. Critics argue that GPs might be incentivized to set a lower sale price to benefit the new fund they manage, potentially disadvantaging existing limited partners who choose to cash out⁴. Conversely, existing LPs might perceive that the GP is holding onto an asset primarily to generate additional management fees, rather than solely for optimal investment performance.

To mitigate these concerns, industry best practices typically involve robust governance, including thorough due diligence by limited partner advisory committees (LPACs) and the use of independent third-party valuations³. However, some studies highlight that despite the supposed "optionality" for investors, many existing investors in the original funds often decline the option to roll over their stakes into a continuation fund². The Securities and Exchange Commission (SEC) has also addressed these potential conflicts, adopting new rules in August 2023 aimed at enhancing regulation of private fund advisers, including aspects relevant to continuation funds and other GP-led secondary transactions¹.

Continuation Funds vs. Private Equity Secondary Market

Continuation funds are a specific type of transaction within the broader private equity secondary market. The private equity secondary market encompasses all transactions where investors buy or sell existing interests in private equity funds or underlying private assets, rather than investing directly in a newly formed primary fund.

The key distinction lies in who initiates the transaction and what is being transferred. Historically, the secondary market was dominated by "LP-led" transactions, where a limited partner sells its existing fund interest to another investor, often to gain liquidity or rebalance its portfolio. In these cases, the fund's underlying assets remain within the original fund structure until its natural wind-down.

In contrast, continuation funds are "GP-led" secondary transactions. Here, the general partner initiates the transaction, typically to move one or more assets from an existing fund nearing its end-of-life into a new fund vehicle that the same GP manages. While the broader secondary market provides liquidity for fund interests, continuation funds specifically focus on providing extended management and a new investment horizon for particular portfolio companies. Therefore, while all continuation funds are secondary market transactions, not all secondary market transactions are continuation funds.

FAQs

What is the main purpose of a continuation fund?

The main purpose is to allow a general partner to extend the holding period for specific high-performing assets from an existing fund that is reaching its end-of-life. This enables the GP to continue managing these assets to realize their full value potential without a forced sale.

How do limited partners participate in a continuation fund?

Existing limited partners from the original fund are typically given a choice: they can either cash out their pro-rata share of the assets being transferred into the continuation fund, or they can roll their investment into the new fund, maintaining their exposure.

Are continuation funds considered part of the primary or secondary market?

Continuation funds are considered part of the private equity secondary market. While the primary market involves investing in new funds directly from their launch, the secondary market deals with buying and selling existing fund interests or assets already held by funds.

What are the potential risks associated with continuation funds?

The primary risk is the potential for conflicts of interest, as the same general partner is on both sides of the transaction (selling from the old fund and buying into the new fund). This can raise concerns about asset valuation and whether the transaction is truly in the best interest of all existing limited partners. Robust governance and independent valuations are crucial to mitigate these risks.

How do continuation funds offer liquidity?

Continuation funds offer liquidity by providing existing limited partners in the original fund with an option to receive cash for their stake in the assets being transferred, rather than waiting for a conventional exit or a full fund liquidation. This allows LPs to manage their capital more actively without waiting for a traditional divestment.