Continuation Vehicle

What is a continuation vehicle?

A continuation vehicle is a new fund raised by the same manager to buy one or more assets out of an older fund it already manages. Existing investors choose: roll their interest into the new vehicle and keep the exposure, or sell and take cash at the transaction price. New investors supply the cash that pays the sellers.

Why a GP does this instead of selling or extending

ILPA's guidance says the GP should articulate, before initiating the transaction, why it is using a continuation fund rather than an alternative, and lists what that rationale should contain: the reasoning for a continuation fund rather than a fund extension, a traditional exit or additional co-investment; the quality and outlook for the selected companies; the amount of new capital required; the projected time to realization; and an exit plan for the new vehicle. ILPA adds that the rationale should be heavily scrutinized where the existing fund still has unfunded capital or is within the first five years of its inception.

That last clause is the tell for whether a deal is what it claims to be. A continuation vehicle in year nine of a fund's life is a liquidity solution. One in year four is something else.

The process, stage by stage

ILPA sets out seven stages, and they are worth knowing in order because the leverage sits early.

• The GP presents to the LPAC its rationale for selling the selected assets into a continuation vehicle, and shares that rationale with all LPs.
• The GP selects and engages an advisor to structure the process, solicit bids and guide the transfer.
• The LPAC reviews the structure of the process and any conflicts.
• The LPAC votes on whether to waive the conflicts, inclusive of the structure of the process. ILPA says the LPAC should have 10 business days to review and the opportunity for an in camera session before the vote.
• Solicitation and diligence, including notification to LPs and portfolio company disclosures made available to acquirers and accessible to LPs, for example through a data room.
• A confidential disclosure document circulated to all LPs with the final proposed terms, any terms that differ from the original LPA, amendments to governing documents, and the framework for allocating transaction expenses.
• Election by LPs to roll pro rata, sell to the acquirer on the terms offered, roll and purchase more, or some combination.

On timing, ILPA's recommendation is no less than 30 calendar days or 20 business days for LPs to evaluate the proposal and return election forms, with bank holidays inside the window accounted for and longer periods considered where an LP has statutory review requirements. In advance of finalizing the acquisition agreement, and no less than 10 business days before terms are set for LP election, the GP should convene the LPAC as a group to review the proposed agreement.

ILPA also states the default for silence: where an LP does not respond in time, the election should be treated as liquidating the interest rather than rolling into the new vehicle, and LPs should never be forced to roll.

The economics the guidance actually fixes

The most negotiated part of a continuation vehicle is whether rolling investors get the deal they already had. ILPA's answer is the status quo option, which LPs must be offered and which it defines as no increase in the management fee rate, no change in the management fee base (for rolling LPs, the same base as the existing fund at the time of the transaction), no increase to the carried interest rate, no decrease to the preferred return hurdle or other GP-favorable changes to the waterfall, and no crystallization of carried interest for rolling investors. It adds that there should be no minimum roll participation threshold required to get that option.

On the GP's own economics, ILPA says that in almost all cases the GP should roll 100 percent of accrued carried interest into the continuation vehicle, that any decision not to roll it all requires a detailed explanation and a description of the alignment incentives for the new vehicle, and that carried interest accruing on interests sold by selling LPs should be rolled into the new vehicle. It accepts that no carry will be crystallized where the existing fund uses a European waterfall and is not yet in carry, in which case alignment has to come from the GP's commitment to the new vehicle instead.

Price validation gets the same treatment. ILPA's general principle is that a competitive process should be run to ensure a fair price was obtained and that the process should include third-party price validation. On fairness opinions specifically it is careful: a fairness opinion from an independent financial adviser, a partial disposition to a third party, or an arms-length transaction through a minority stake may be helpful in assessing whether the process was structured to obtain a fair price, and LPs as a group may request that the GP commission a fairness opinion from an adviser independent of the GP's own advisor. ILPA's reason for flagging it is concrete: NAV is determined by the GP, and a trailing number is typically used for discussion during solicitation.

Where regulation stands

For a period it looked as though the fairness opinion would stop being optional. The SEC's Private Fund Advisers final rule included an adviser-led secondaries rule requiring registered private fund advisers to obtain and distribute to investors an independent fairness or valuation opinion and to disclose any relationship with the opinion provider, on the stated ground that it would help prevent investors from being defrauded, manipulated and deceived when the adviser is on both sides of the transaction.

On June 5, 2024 the United States Court of Appeals for the Fifth Circuit, in National Association of Private Fund Managers v. SEC, No. 23-60471, held that the Commission had exceeded its statutory authority and vacated the final rule. The opinion is explicit that because promulgation was unauthorized, no part of it can stand.

So the adviser-led secondaries requirement is not in force. What remains is ILPA's voluntary guidance and whatever the fund's own LPA requires, which is why ILPA's advice to avoid LPA terms that pre-clear conflicts associated with these transactions at the outset of a fund now carries more weight than it did when the rule looked likely to survive.

Worked example, arithmetic shown

All figures are hypothetical.

A 2016-vintage fund has two companies left and moves them into a continuation vehicle at an agreed value of $400,000,000.

Step one, split the elections.

• Rolling LPs: 45 percent of the fund's interest. 0.45 x $400,000,000 = $180,000,000 of continuing interest.
• Selling LPs: 55 percent. 0.55 x $400,000,000 = $220,000,000 of cash required.
• Check: $180,000,000 + $220,000,000 = $400,000,000, the full agreed value.

Step two, add the new capital. The acquirer syndicate commits a further $80,000,000 for follow-on investment in the two companies.

• Total vehicle equity: $180,000,000 + $220,000,000 + $80,000,000 = $480,000,000.

Step three, compute post-closing ownership of the vehicle.

• Rolling LPs: $180,000,000 / $480,000,000 = 37.5 percent.
• New money, being the $220,000,000 purchase plus the $80,000,000 commitment: $300,000,000 / $480,000,000 = 62.5 percent.
• Check: 37.5 + 62.5 = 100 percent.

Step four, notice the dilution. The rolling LPs held 45 percent of the asset value before the follow-on capital and 37.5 percent of the vehicle after it, a 7.5 point reduction caused entirely by the new money. ILPA treats this as a live issue: any resulting dilution of existing LPs should be on a fair and reasonable basis, and where rolling LPs are diluted the GP should give a commercial rationale, with the dilution priced at the same entry valuation as the transaction, at a market value set by independent advisers when the capital goes in, or mitigated through an instrument that does not dilute the rolling LPs' equity.

Step five, calendar the process against the guidance. LPAC review before the conflicts vote: 10 business days. LPAC meeting before terms are finalized: no less than 10 business days earlier. LP election window: no less than 30 calendar days or 20 business days. Non-response: treated as a sale.

Common mistakes

• Reading the price as the deal. The status quo option, the carry roll and the dilution mechanics move more value for a rolling LP than a point of NAV does.
• Accepting a compressed election window. ILPA's floor is 30 calendar days or 20 business days, and it says GPs should strive for more.
• Assuming an LPAC conflict waiver protects LPs. ILPA notes that individuals on the LPAC act in their own interests, do not owe a fiduciary duty to the fund or other LPs, and should be indemnified, and that the LPAC should not be asked to recommend that LPs approve the transaction or any LPA amendments.
• Letting the fund's LPA pre-clear these conflicts at formation. ILPA says to avoid such terms and to mitigate and clear conflicts when they arise.
• Treating a fairness opinion as mandatory. It was going to be, under a rule that no longer exists; today it is a negotiating point.
• Ignoring information parity. ILPA says GPs should endeavor to achieve parity between what the acquirer sees and what LPs see, with data room access to all LPs at the earliest opportunity.

How it relates to adjacent terms

A continuation vehicle is one form of GP-led secondary; a strip sale, which moves a slice of several assets rather than whole positions, is another, and a tender offer run at the fund level is a third. It interacts directly with carried interest, because whether accrued carry crystallizes or rolls is the main alignment question, and with the European waterfall, under which a fund not yet in carry has nothing to crystallize.

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