Continuation Funds as a Tool for Creating Liquidity
In recent years, the previously rare continuation funds have become more common as a way to create liquidity in close-ended funds. Continuation funds enable the realisation of an investment in such a manner that the fund manager retains control and has the possibility to benefit from a potential future increase in value of the investment target. In this post, I present some central special characteristics of continuation funds that fund managers and investors should keep in mind.
What Are Continuation Funds?
In an average continuation fund transaction, a continuation fund purchases one or several investment targets in a fund that is managed by the same fund manager and often near the end of its term. Investors of the existing fund have the option to either sell (i.e. redeem) their investment or to transfer it to the continuation fund. Completely new investors pay their commitments to the continuation fund, which provides liquidity for those investors of the existing fund that have decided to withdraw from the investment target. The terms and conditions of the continuation funds are negotiated between the fund manager and the new investors, and they often vary according to the asset categories that are the object of the continuation fund transaction.
When used strategically correctly, a continuation fund can satisfy the interests of the different stakeholders and achieve several targets: it can offer a liquidity window for current investors wishing to withdraw, balance conflicting interests, customise incentives and extend the holding period of the investment targets to maximise their value creation.
Continuation fund transactions are, however, complex transactions, and if the process to arrange them is weak, it often damages the fund manager’s reputation. A successful establishment of a continuation fund requires that the investors are provided with a clear business justification, that the transaction structure is created in a manner that solves the main legal and tax challenges and that the legal and commercial process is efficiently managed.
The Main Contradiction
A substantial portion of continuation fund transactions facilitated by fund managers is never completed. Common reasons for this are disagreements on the fair value and the grounds justifying the transaction. Some investors may be worried about the justifications: is the fund manager actually trying to hold on to a high-quality investment target or is the ultimate purpose of the transaction to dump to the continuation fund unprofitable investment target that could not be realised at an appropriate price on the normal market? There may also be suspicions that the fund manager might want to use a continuation fund to hold on to the fees relating to the investment targets that they would not get if the investment was realised to a third party.
Usually, the dynamics of a continuation fund transaction are more complex than a typical withdrawal from a target company, as in practice the fund manager acts as both parties in the transaction. To create an attractive liquidity alternative, the fund manager must offer the potential buyers an attractive transaction proposal and price.
On the other hand, acting as the seller, the fund manager also has the duty of care towards the existing fund: in practice, the sales cannot be executed unless a sufficient number of existing investors are persuaded to support the sales. Sometimes the fund manager can also ask the buyers for a group commitment to another fund raised by the fund manager, which may increase the complexity of the transaction. When there is a conflict of interests, measures and justifications are necessary to make the transaction credible and satisfactory to both parties.
Starting the Procedure
If you are an investor considering investing in a continuation fund, we recommend consulting advisors at an early stage. The legal documentation of the existing fund and its investment targets should be carefully reviewed so that any required approvals and potential restrictions, such as regulatory issues or transfer restrictions, can be identified.
Tax advice is necessary for the potentially complex structuring of the transactions, in particular, if the existing investors are to invest in the continuation fund in a tax-neutral manner. Financial advisors are often needed to help with the coordination of marketing, the commercial process and investor relations, as well as with proving the transparency and impartiality of the valuation and sales process to the investors. Sometimes further assessments on whether the transactions are market-based are obtained.
As continuation fund transactions are, as a rule, insider transactions, they typically require an approval by the existing fund’s advisory committee or investors. The recommendation is that the fund manager hears the advisory committee before planning the transaction very far. This helps in demonstrating transparency and increasing the investors’ trust, both of which are very important in ensuring a smooth process.
Discovering Buyers and Negotiating Terms and Conditions
After forming the team of advisors, the fund manager should identify potential buyers. These could include single investors or a consortium. Buyers will become investors of the continuation fund and thus provide liquidity for the investors of the earlier fund.
The fund manager can find buyers through their contacts or, for example, through a bidding process. The bidding process is usually managed by the financial advisor who assists in determining the fair value and relieves investors’ concerns relating to the impacts that the fund manager’s conflicts of interests may have on the transaction.
After the potential buyers have been identified, the negotiations that follow can be a significant phase that requires expertise both in funds and in corporate transactions. Even though the terms and conditions of the existing fund can be used as a basis for certain conditions, the central terms and conditions of continuation fund transactions are usually customised. These include financial terms, the fund manager’s own investment, conditions on new investor protection, issues concerning uncalled commitments between current and new investors as well as conditions concerning transferable assets and the minimum number of transferring investors. All existing investors’ side letters should be reviewed, and fund managers should be prepared in case the investors want to renegotiate their side letters at this stage.
As establishing a continuation fund is ordinary fundraising, fund managers should take into account all provisions that are usually applied, such as applications and approvals relating to the marketing of the funds.
What Should Current Investors Take into Account?
A disclosure memorandum is usually drawn up for the current investors. In addition to the details concerning the transaction, the memorandum includes important legal information and often also a form with which the investors can partially withdraw from the current fund or transfer a part of their holdings to the continuation fund.
Often current investors can also make an additional commitment to the continuation fund increasing their relative indirect exposure to the transferring investment targets. Any necessary approvals of the advisory committee and existing investors are also obtained at this stage.
As an exit arranged through a continuation fund deviates from an ordinary exit, it is quite common for the fund agreement to require obtaining an approval of the existing investors. This is usually sensible also considering the fund manager’s liability risks. However, some fund agreements determine permissible inside transfers broadly in such a way that the earlier fund can transfer its holdings in an investment target to any fund managed by the fund manager or its subsidiaries, including a continuation fund.
From the investors’ and fund managers’ point of view, it is recommended that the possibility of establishing a continuation fund is discussed already in conjunction with the fundraising for the original fund in order to avoid surprises towards the end of the fund’s term.
Successful Completion of the Transaction
When investors have decided whether they want to withdraw or transfer their holdings and all preconditions have been fulfilled (e.g. authority approvals have been received), the transaction can be completed. Withdrawing investors are distributed profit, the existing fund can realise the investment target and the continuation fund takes responsibility for holding and developing the investment target.
The key to a successful continuation fund transaction is commencing close cooperation with the investors already at an early stage, and a transparent process for determining the price supports such cooperation. Another critical issue is coordinating the interests of the current and new investors in an appropriate and fair manner, which requires thorough consideration of legal, financial and tax matters.
If you wish to discuss the themes of this blog in more detail, please do not hesitate to contact our Private Equity & Venture Capital team.