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In recent years, previously rare continuation funds have become more common as a means of creating liquidity in closed-end funds. Continuation funds allow an investment to be made in such a way that the fund manager retains control and has the opportunity to benefit from any future appreciation of the investment objective. In this article, I outline 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 buys one or more investment targets in a fund managed by the same fund manager and often at the end of its life. Investors in the existing fund have the option of selling (i.e. redeeming) their investment or transferring it to the continuation fund. Greenfield investors pay their commitments to the continuation fund, which provides liquidity to investors in the existing fund who have decided to withdraw from the investment objective. The terms and conditions of continuation funds are negotiated between the fund manager and new investors, and they often vary depending on the asset classes that are the subject of the continuation fund transaction.
When used strategically correctly, a continuation fund can satisfy the interests of different stakeholders and achieve several objectives: it can provide a window of liquidity for current investors wishing to exit, balance conflicting interests, personalize incentives and extend the holding period of the investment objectives to maximize their value creation.
Continuation fund transactions are complex transactions, however, and if the process for arranging them is weak, it often damages the reputation of the fund manager. Successful creation of a continuation fund requires that investors receive a clear business rationale, that the deal structure is created in a way that addresses key legal and tax issues, and that the legal and business process is managed efficiently.
The main discrepancy
A significant part of the continuation fund transactions facilitated by fund managers are never completed. Common reasons for this are disagreements over fair value and the reasons for the transaction. Some investors may worry about justifications: is the fund manager really trying to maintain a high-quality investment objective or is the ultimate purpose of the transaction to transfer an investment objective to the continuation fund? unprofitable that could not be realized at an appropriate time? normal market price? There may also be suspicions that the fund manager might want to use a continuation fund to retain fees related to the investment objectives that he would not get if the investment was made for the benefit of a third party.
Usually, the dynamics of a continuation fund transaction are more complex than a typical exit from a target company, because in practice the fund manager acts as both parties in the transaction. To create an attractive liquidity alternative, the fund manager must offer potential buyers an attractive deal proposal and price.
On the other hand, acting as a seller, the fund manager also has a duty of care towards the existing fund: in practice, sales can only be executed if a sufficient number of existing investors are persuaded to support the sales. . Sometimes the fund manager may also ask buyers for a collective commitment to another fund raised by the fund manager, which can increase the complexity of the transaction. When there is a conflict of interest, measures and justifications are necessary to make the transaction credible and satisfactory for both parties.
Starting the procedure
If you are an investor considering investing in a continuation fund, we recommend consulting with advisors at an early stage. The legal documentation of the existing fund and its investment objectives 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 required for the potentially complex structuring of transactions, particularly if existing investors are to invest in the continuation fund in a tax-neutral manner. Financial advisors are often needed to help coordinate the marketing, business process, and investor relations, as well as demonstrate the transparency and fairness of the valuation and sales process to investors. Sometimes additional assessments of whether transactions are market-based are obtained.
As continuation fund transactions are, as a rule, insider trading, they generally require the approval of the advisory board or investors of the existing fund. The recommendation is that the fund manager hear from the advisory board before planning the deal very far. This helps to demonstrate transparency and increase investor confidence, two very important elements to ensure a smooth process.
Discover buyers and negotiate terms and conditions
After forming the team of advisors, the fund manager must identify potential buyers. These could be single investors or a consortium. Buyers will become investors in the continuation fund and thus provide liquidity to investors in the previous fund.
The fund manager can find buyers through his contacts or, for example, through a bidding process. The bidding process is typically managed by the financial advisor who helps determine fair value and allays investors’ concerns about the impacts that the fund manager’s conflicts of interest may have on the transaction.
Once the potential buyers have been identified, the ensuing negotiations can be an important phase that requires expertise in both funds and corporate operations. Even though the terms and conditions of the existing fund can be used as the basis for certain conditions, the central terms and conditions of continuation fund transactions are generally personalized. These include financial terms, the fund manager’s own investment, new investor protection terms, issues regarding uncalled commitments between current investors and new investors as well as terms regarding transferable assets and minimum number of transferring investors. All existing investor side letters should be reviewed and fund managers should be prepared in case investors wish to renegotiate their side letters at this stage.
Since the establishment of a continuation fund is a normal fundraiser, fund managers must consider all the provisions usually applied, such as applications and approvals relating to the marketing of the funds.
What should current investors consider?
An information memorandum is usually written for current investors. In addition to details about the transaction, the memorandum includes important legal information and often also a form with which investors can partially withdraw from the current fund or transfer part of their holdings to the continuation fund.
Often, current investors can also make an additional commitment to the Continuation Fund, increasing their indirect exposure relative to transferred investment targets. All necessary approvals from the Advisory Board and existing investors are also obtained at this stage.
As an organized exit through a continuation fund is a departure from an ordinary exit, it is quite common for the fund deal to require obtaining approval from existing investors. This is generally wise given the liability risks of the fund manager. However, some fund agreements determine permitted internal transfers generally such that the predecessor fund may transfer its holdings in an investment target to any fund managed by the fund manager or its affiliates, including a continuation fund. .
From the point of view of investors and fund managers, it is recommended that the possibility of creating a continuation fund be discussed already in conjunction with the fundraising for the original fund in order to avoid surprises towards the end of the duration of the fund.
Successful completion of the transaction
When investors have decided whether they wish to withdraw or transfer their holdings and all preconditions have been met (for example, approvals from the authorities have been received), the transaction can be finalized. Investors who take profits are distributed, the existing fund can achieve the investment objective, and the continuation fund takes responsibility for holding and developing the investment objective.
The key to a successful continuation fund transaction is to engage in close cooperation with investors early on, and a transparent pricing process supports such cooperation. Another critical issue is the coordination of the interests of current and new investors in an appropriate and fair manner, which requires careful consideration of legal, financial and tax issues.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.