Continuation Funds
The Risks of Continuation Funds: What Limited Partners Should Consider
Continuation funds have gained traction as an increasingly common tool for private equity firms to extend the life of existing investments. By transferring portfolio assets from an existing fund to a new vehicle—often with the participation of new investors—general partners (GPs) can secure additional time and capital to maximize value. However, while continuation funds may offer benefits, they also come with notable risks for limited partners (LPs). Below, we highlight the primary risks LPs should be aware of.
1. Conflicts of Interest
Continuation funds often create inherent conflicts of interest between GPs and LPs. These conflicts arise from:
Self-Determined Valuations: GPs typically drive the valuation of assets being transferred to the continuation fund. This creates a potential for overvaluation, particularly if the GP’s reputation or compensation is tied to the perceived success of the original fund.
Dual Fiduciary Duties: GPs must balance their fiduciary duties to LPs in both the original and continuation funds, which can lead to decisions that prioritize one group over the other.
2. Increased Fees and Expenses
Continuation funds can result in higher costs for LPs, which may erode returns. These include:
Transaction Costs: The transfer of assets from the original fund to the continuation fund often incurs legal, advisory, and administrative fees.
New Management Fees: LPs who roll over into the continuation fund may be subject to a new set of management fees, even if they have already paid substantial fees in the original fund.
Additional Carry: A continuation fund typically restructures the carried interest terms, potentially requiring limited partners (LPs) to pay additional carried interest in the new vehicle. Importantly, LPs might still incur carry obligations even if the aggregate performance of the investment resulted in a loss or failed to surpass the preferred return threshold that would traditionally trigger the general partner’s (GP) entitlement to carried interest. This creates a scenario where LPs could bear carry costs despite the investment underperforming relative to initial expectations or contractual benchmarks.
3. Limited Transparency and Input
LPs often have limited influence over the terms and structure of a continuation fund. Key concerns include:
Restricted Information: LPs may not have full visibility into the GP’s decision-making process or the rationale behind the continuation fund.
Take-It-or-Leave-It Options: LPs in the original fund are often given limited choices—either roll over into the continuation fund or sell their interest, potentially at a discount.
4. Concentration Risk
Continuation funds can increase concentration risk for LPs, particularly those who roll over their investments. Instead of diversifying into new opportunities, LPs remain exposed to the same portfolio assets, which may:
Underperform Expectations: Assets in continuation funds are often those that require more time to achieve targeted returns, increasing the risk of underperformance.
Face Market Volatility: Prolonged holding periods may expose assets to greater market fluctuations, regulatory changes, or industry-specific downturns.
5. Potential Misalignment of Interests
Continuation funds can lead to misaligned incentives between GPs and LPs due to the following:
GP Liquidity: GPs often use continuation funds as a way to realize liquidity while continuing to manage the assets. This can reduce their motivation to optimize long-term performance, especially if the GP has received a significant carried interest distribution from the original fund.
Preferential Treatment for New Investors: New investors in the continuation fund may negotiate more favorable terms, potentially disadvantaging rollover LPs from the original fund.
What LPs Should Do
To mitigate these risks, LPs should take proactive steps, including:
Demand Independent Valuations: Insist on third-party valuations from a neutral valuation agent to ensure fair pricing of assets transferred to the continuation fund.
Scrutinize Fee Structures: Carefully evaluate the cumulative fees and carry to determine whether the continuation fund represents a fair value proposition.
Engage in Negotiations: Where possible, advocate for terms that align GP and LP interests and provide equal treatment to all investors.
Assess the Rationale: Understand the GP’s rationale for creating the continuation fund and evaluate whether it aligns with the LP’s investment goals.
Continuation funds can offer a viable solution for extending the lifecycle of portfolio investments, but they are not without significant risks. By staying vigilant and actively participating in the process, LPs can better protect their interests and ensure alignment with their broader investment objectives.
