Written By Jonathan McCullough, Elizabeth Dylke and Kyle Falk-Varcoe
The Institutional Limited Partner Association (ILPA) published new guidance on May 15, 2023, relating to continuation funds. The guidelines build on ILPA's prior (2019) guidance on best practices for GP-led secondary fund structuring, detailing considerations for Limited Partners (LPs) and General Partners (GPs) planning to engage in continuation fund transactions.
Continuation funds are an increasingly popular method for GPs to maximize the value of well-performing investments in their portfolio that have future potential, while also relieving the pressure of having to sell assets prematurely. Continuation funds allow GPs to move one or more assets into a new investment vehicle, while giving LPs the option to either roll their interests into the new vehicle, opt out of the new vehicle and receive a cash distribution, or undertake some combination of the two. More detail on continuation funds can be found in our blog post Continuation Funds: A Growing Trend. The new ILPA guidance responds to several key concerns of LPs that arise from the increased use of continuation funds.
First, continuation funds are more complex and demand greater information disclosure than standard private equity funds, because continuation funds require LPs to assess investment opportunities in individual assets rather than larger funds or fund managers with a specified investment strategy and track record. Second, continuation funds often provide investors with short timelines within which they must make a decision on whether to opt in or out of the new vehicle, sometimes as little as 10 days, which may limit the capacity of LPs to adequately review and make informed decisions. Third, the structure of a continuation fund transaction, where GPs have an interest on both the buy-side and the sell-side, is an inherent conflict of interest and is an important issue to address for LPs when it comes time to negotiate the terms of the continuation fund. The ILPA guidelines are intended to lessen the difficulty caused by these key concerns and to better align the interests of GPs and LPs in continuation funds.
Information Disclosure for Continuation Funds
To assist LPs with the complexity of continuation fund decisions, the ILPA guidance urges GPs to provide LPs with detailed advance disclosure of all information necessary for them to carry out diligence on the assets to be included in the continuation fund. GPs are recommended to provide both the Limited Partner Advisory Committee (LPAC) and LPs information on (1) the justification for establishing a continuation fund as opposed to alternative options, such as a fund extension or third party sale; (2) the value and outlook for the assets to be transitioned into the continuation fund; (3) the amount of capital required for the continuation fund, both from existing LPs and incoming LPs; (4) the projected time to fully realize the transitioned asset; and (5) the exit plan for the continuation fund. The ILPA guidance also recommends that once the final terms of a proposed continuation fund transaction have been set, all LPs should have access to the same information about the process as LPAC members. GPs should provide information relevant to establishing the proposed price, including historical valuation of the asset, whether there has been a recent minority equity sale in the target business, the existence of an independent valuation or fairness opinion, and, if the investment has been marketed, the number, range, and content of bids considered, whether any LPAC members are participating in the bidding process, and the rationale for why the GP chose the selected bid.
To limit the impact that the timelines and processes of continuation fund transactions have on the decision-making of LPs, ILPA guidance recommends that LPs should have sufficient time to thoroughly evaluate the GP proposals, which would be 30 calendar days at a minimum. ILPA recognizes that some investors may have institutional legal requirements, including statutory requirements, that may require additional due diligence. Similarly, the short timelines of many continuation funds do not adequately account for the investment committee schedules of LPs. GPs should therefore consider the specific requirements of the LPs to ensure they are afforded adequate time to make a decision on whether to roll into the continuation fund or to liquidate their investment.
Conflict and Commercial Terms
To respond to the problem of the inherent conflict of GPs being on both sides of the transaction, the ILPA guidance recommends changes to the continuation fund transaction process. ILPA guidance recommends that LPACs have a chance to vote on whether to waive any conflicts of interest associated with the continuation fund transaction. Similarly, ILPA recommends that the LPAC have access to an experienced independent legal and specialist advisers to advise on the structure, terms, and valuation used by GPs, as well as detail the possible conflicts that LPs must waive to complete the transaction.
To reduce the conflicts that arise, ILPA also recommends that GPs appoint third party advisers to help facilitate the continuation fund transaction. The adviser's role would be to generally benefit the initial fund overall, and not exclusively advise in the interests of the GP. The adviser should be engaged to solicit bids for the assets being contemplated for the continuation fund, and information in the appointment and scope of the adviser should be made available to the LPAC. The ILPA guidance also highlights that in some cases LPs may benefit from an independent assessment of the value of the underlying assets of the fund, as well as the commission of a fairness opinion, in order to allow them to make an informed decision.
Related to concerns over the conflict of the interest of GPs on both sides of the transaction, ILPA guidance emphasizes that LPs should have a chance to participate in the continuation fund on generally the same economic and legal terms as they had in the initial fund. ILPA guidance recommends that the continuation fund has (1) no increase in the management fee; (2) no increase in carried interest rate or other GP-favourable changes to the distribution waterfall; (3) no crystallization of carried interest in relation to rolling LPs' interests; and (4) all carried interest crystalized from selling LPs should be reinvested into the new continuation fund. The crystallization of carried interest is considered to be one of the key benefits that GPs gain from the use of continuation funds, making this recommendation potentially significant. ILPA also recommends that LPs that roll into the continuation fund should have their side letters, if any, transitioned into the continuation fund as applicable.
The impact of the new ILPA guidance on continuation funds remains to be seen. GPs and LPs planning to engage in continuation fund transactions should both be mindful of the recommendations and how they may influence negotiations and timelines.
If you have any questions about the information in this blog post or regarding the updated ILPA guidance, please contact the authors or a member of the Bennett Jones Private Equity & Investment Funds group.