Typically, when a private equity fund approaches its contractual culmination point, it will seek to sell its assets, but this may not be possible or desirable at that moment. Establishing a continuation fund is an alternative, Laurent Capolaghi, partner and private equity leader at EY Luxembourg, explained in this Q&A. One third of the top 50 PE houses are considering this alternative option, he estimates.
A continuation fund enables prized assets to be transferred to a new vehicle while maintaining characteristics of the legacy fund. Such a fund is a vehicle established by the general partners - the GPs - of an existing private equity fund, into which some or all of the assets of legacy funds are sold. The GP will normally remain the same, and many of the limited partners - the LPs - will roll over their investments into the new fund.
Investment Officer: What motivates a PE fund to establish a continuation fund?
Laurent Capolaghi: It is an option when other exit routes are not open or are not ideal as the fund approaches the end of its contractually agreed lifespan. A trade sale might not be an option if potential corporate buyers are more focused on adjusting their existing business to the challenging economic environment. The secondaries market is still very active, but might not be appropriate, and IPOs are difficult in current market conditions. Yet if these funds are sitting on assets they have grown, believe in and value, a continuation fund is an exit route which can allow the full potential of the company to be unlocked, and then monetised at a more appropriate time.
IO: What are the advantages of a continuation fund?
LC: It gives extra flexibility so that a solution can be tailor made. The first attraction is that it enables LPs to remain invested in assets they know, with a GP team and other investors that they are comfortable with. It makes it much easier to sell this configuration fund to existing investors and third parties as the buy-and-build work has already been done. Given the continuity it enables preferential treatment and lower setup fees for LPs. GPs can decide to only give legacy LPs the option to continue, or fresh investment can be sought from third parties. A completely separate fund would require more money to be raised and would take longer to organise. Investing in a continuation fund, gives more certainty about what will happen as opposed to investing in 2022 to 2023 vintage funds.
IO: What formats can these funds take?
LC: The limited partnership structure does not change, as the options in Luxembourg are light and easy to tailor. These can either feature a single asset, or alternatively multiple assets from one or several funds of different vintages. The market tendency seems to be moving towards single asset continuation funds, but overall there is a 50/50 split between the two models.
IO: How prevalent is the use of this option?
LC: We estimate that one-third of the top 50 private equity houses are using or are considering proposing continuation funds to their investors. Assets under management in these vehicles have gone from 27 billion dollars in 2019 to 65 billion in 2021. There is no reason why this concept couldn’t be used for other close-end time-limited funds, such as in the real estate and infrastructure sectors.
IO: What are the potential problems?
LC: The potential for conflict of interests needs to be managed. Most notably, the price at which the legacy fund sells assets needs to be fair, because there is generally the same GP for both the seller and purchaser. A safeguard could be an advisory committee at the level of both structures making independent valuations. Alternatively the LPs at both funds could agree on the price. Another potential conflict of interest arises in terms of the governance if the same people are looking at the same investments, but maybe don’t have the expertise required to help take the assets to its next level of growth.
IO: What is the regulatory outlook?
LC: There is nothing specific in the AIFMD, and neither ESMA nor the CSSF has offered guidance. The SEC in the US has published notices regarding conflict of interests such as the pricing of the transaction. So yes, there is scrutiny already in the US and scrutiny on compliance with AIFMD valuation and conflicts of interest rules is to be expected from national competent authorities at the European level too.