Continuation funds provide valuable source of liquidity in uncertain markets

Issue

Historically, fund managers have used continuation funds to hold on to trophy assets or portfolios of investments with clear remaining upsides. However, in the current economic climate, they are increasingly being used as a way to generate liquidity.

The term “continuation fund” may involve an extension of an existing fund’s term, but normally sees the majority of a fund’s portfolio rolled over into a new fund managed by the same sponsor. Where existing investors wish to exit the discontinuing fund, their liquidity is created by the continuation fund acquiring the discontinuing fund’s relevant investments. Funding comes via a fresh capital-raise from new investors or existing investors who want to increase their exposure, with those who don’t want to exit rolling their existing interests over into the continuation fund. There may be new financing or refinancing of investments at the same time, although often a sponsor may be in a position to say there is no change of control thanks to their continued management of the continuation fund.

There may be mechanisms in the existing fund documents that allow the manager to extend the fund’s life for a short period (say one or two years) with investor consents, but further extensions will usually require the unanimous support of existing investors.

Where this is likely to be challenging, the manager will typically create a new fund. Here, one or more current investors and/or a new investor will come on board as the lead investor(s), generally after negotiating enhanced governance rights. Once the lead investor is in place, the rest of the existing investors will either roll over into the continuation fund or be bought out.

Continuation funds offer several advantages for managers

Continuation funds offer fund managers the prospect of ongoing management fees and further carry or performance fees (both on “exit” of the existing fund and under the terms of the continuation fund). In some cases, the terms may require the fund manager to inject capital into the continuation fund and/or roll over its fees into the new vehicle to build greater alignment with investors.

The transition to the new continuation fund may require the underlying fund documents to be adapted to take into account tax or other regulatory changes. In some cases, the continuation fund may be able to pursue further investments that would have been restricted under the terms of the existing fund.

Concerns have been raised about the potential for conflicts of interest in the use of continuation funds, given that the fund manager is acting for both the seller (the existing fund) and the buyer of the assets (the new continuation fund). Broadly, these conflicts fall into three areas.

Common law (or equivalent) fiduciary duties

Fund managers will often owe a common law duty to each fund, which means they must not (at least without prior authorisation or consent):

• put themselves in a position where their personal interests conflict with those of the fund as their client; or 
• make a profit from their fiduciary office. (That said, the commercial reality is that managers will invariably have multiple clients, and complete fidelity may therefore not be possible. As a result, the courts generally recognise that these fiduciary duties can be modified contractually).

Regulatory duties

To manage these potential conflicts, most regulatory regimes impose parallel obligations that must be considered alongside these common law duties.

Contractual conflicts

Fund documents will typically include provisions to deal with conflicts of interest. It’s common to see:

• general pre-disclosure of a wide range of potential conflicts that the fund manager may be subject to;
• mechanisms for the approval of specific types of conflicts (e.g. related party transactions);
• a requirement for the fund manager to provide certain information about particular conflicts (e.g. sums paid by the fund for related party services); and
• approvals enabling the fund to retain transaction fees so as not to breach the “no profit” rule.

Solutions

We have recently incorporated specific provisions into existing fund documents to address the possibility of a continuation fund in the future. These provisions entitle the fund manager to establish a continuation fund that will acquire investments from the existing fund on fair and reasonable terms within pre-agreed conditions (relating to the sale price and the process by which the continuation fund is established).

Where it’s not possible to implement these contractual measures, or where the proposed continuation fund is different to that envisaged in the fund documents, the fund manager may need to implement two teams to manage potential conflicts. However, if the consent of existing investors is still required, they may not be willing to provide such consent even where these structures are in place.

Managers look at range of options to manage potential conflicts

We’re increasingly seeing parties agree to independent valuations of the existing fund’s assets to provide a degree of comfort to existing investors (indeed U.S. regulators are now mandating such fairness opinions from independent third parties).

Some fund managers are even pursuing auction processes with the continuation fund among other bidders. In this situation it’s important to ensure symmetrical disclosure of information in an indexed data room.

Key continuation fund terms

• Where the continuation fund isn’t looking to acquire new assets, its management fee is usually lower than that of the existing fund, and is tied to the cost of investments held and the term of the fund itself.
• Carry or performance fee waterfalls are often highly structured with multiple tiers to include both internal rates of return and hurdles/preferred rates of return. There may be separate hurdle rates for each of the underlying investments/assets.
• Fund manager no-fault removal rights are heavily negotiated. Investors in continuation funds often seek greater removal rights than those in the existing fund as well as tighter controls over the vesting of carried interest.
• Investors often have more control over extension requests and may seek the power to decide when to exit assets. This could be via a forced sale upon request from one or more of the investors; providing for a call/put option in favour of one of more of the investors; or simply requiring prior investor approval.
• We sometimes see cases where the existing fund is open-ended but the proposed continuation fund is closed-ended. In these scenarios, the continuation fund is often designed to provide liquidity to cover redemption requests from existing investors, and the manager may need to get a hard commitment from those that are rolling over to ensure they won’t submit redemption requests while the continuation fund is being established.
• Finally, early engagement is required to ensure the continuation fund is structured to avoid any unintended tax charges. The key focus areas are likely to be transfer taxes (e.g. stamp duties, registration duties and other similar charges) which could kick in when assets are moved between funds.

There are a number of points in the process of establishing and maintaining a continuation fund at which the manager may require additional liquidity, be it to fund the GP commitment in the continuation fund, to finance part of the acquisition price for the portfolio, or to fund follow-on investments.

In the right circumstances, subscription-line financing, NAV facilities and hybrid financings may all be available to the continuation fund, providing the same benefits and attractions as for traditional funds. The unique features of continuation funds – which tend to involve more concentrated asset pools and smaller investor bases – mean that the pool of providers of such financings is typically smaller than for traditional funds, and the structures are more typically hybrid financings collateralised by a mixture of the continuation fund’s underlying assets and investor commitments.

However, we have also seen continuation funds use subscription-line financing for liquidity strategies such as deferring some or all of the purchase price payable for portfolio assets (which can boost the IRR), providing new capital for follow-on investments (where the fund mandate permits) and/or buying out existing investors that do not wish to roll over their commitments.

For more on continuation funds in a real estate context – including what to look for in key documents – read our detailed briefing.