Chris C: Welcome to the GPFS podcast. My name is Chris Calogero, Senior Director of Fund Administration.

Brad A: And I'm Brad Aperance. I'm one of the fund directors, at GPFS as well.

Chris C: Brad and I today are going to talk about a product that's been around for about a decade or so, but has really started to take off in popularity in the last few years, and that's the continuation fund.

We're going to kind of dive in, high level overview on what it is, the considerations that both GPs and LPs should take into account when deciding whether to offer and or invest into these funds, and then for those of us on the support side, things that we need to be aware of as well. So without further ado, let's start with an easy question.

Chris C: Brad, what is a continuation fund exactly?

Brad A: Yeah. So a continuation fund, I think kind of setting the stage with private equity funds, it's a long term investment.

Limited partners are expected to make a commitment to a fund, and they're typically committing to a 10 to 15 year timeline. Whenever liquidity is needed, if at all, before that timeline ends, you know, there was very commonly, what's called an LP led secondary. That's where an LP would, sell their interest to another, new incoming LP, and that would provide them with liquidity and some flexibility when they needed it. But what, continuation fund is, it's something that's been around for a while, but it's definitely in this current market where exits are less frequent, liquidity is a little more scarce than it was a few years ago, pre COVID, pre banking crisis.

It's a continuation fund is a certain type of GP led secondary, and that is when, the general partner sees that we're getting to the end of a private equity fund. The lifetime, the term, or the partnership agreement is getting to the end. They may decide that one or more of their assets is not quite ready yet. Maybe it's a situation where the investment needs more time. Maybe it was distressed, during all these crises that we've had over the last few years. And it's something where they want to either give it more time to mature, where they can get the asset to a point that is to maximize its value with an exit. Maybe they want to provide more capital to it, so they want to have a transaction where new investors can come in, or maybe it's something where they want to have some additional acquisitions, maybe take some competitors off the board before they bring it to market. So when that type of situation arises, what they may want to do is create a continuation fund, and that allows the existing fund to sell one or more of those assets to the new entity at a point, and then it allows the limited partners some flexibility where they can either sell their interest at that time and get out of the the fund and the investment entirely.

They can roll their equity over into the continuation fund and extend the life of their investment in the fund, now in a new vehicle, or they could also roll their equity in and add some additional commitment. Maybe they want to put in additional capital so that their ownership in this asset isn't diluted. Maybe they see the value and that they want to extend their timeline as well. It could be some combination of a few of those scenarios where they they may roll and, or partially exit and also increase their commitment at the same time. So with that, a continuation fund will typically have an additional timeline of maybe another five years, maybe it could have another opportunity for extension after that depending on the investments.

But that's really an overview just to set the stage of what the fund is.

Chris C: Right. So on that, it's interesting.

The GP is on both sides of the transaction here, right, because they're selling the asset from the underlying fund to the newly created continuation fund.

Chris C: So with the GP on both sides here, how does it ensure that the price that's being offered to LPs, whether or not they want to take the money and run or roll into the new fund, how do they make sure it's a fair price that's being offered?

Brad A: Yeah. That's a great point. And that's really one of the overarching concerns, I guess, you know, that LPs have over continuation funds is making sure that, you know, when they get a request from a from a GP to to either, that they're doing the secondary transaction, they want tp understand everything about it. They want to, make sure that the alignment of the interest that they had when they first committed to the initial fund still exists, that they know the rationale for this investment, that they understand what is the current proposed value for this transaction and what it could be in the future. Why is the GP looking to extend the timeline? So you know, really to make sure the key is, I think, transparency, making sure that, you know, as a GP, you're keeping your LPs, your investors, your partners, you know, in the conversation the entire way.

You know, one way to do that is to use your LPAC, your advisory committee. Most funds, it's a mandate to have one at this point, especially your larger buyout funds. So really, you know, floating a test balloon with them can be very helpful. Really speaking with the LPAC, laying out the idea for the secondary, this continuation fund transaction, talking to them about why you want to do it, why is it in the LP's best interest to do this besides just the option for liquidity?

Why should they decide to roll equity into the investment?

And then to your question, talking about the valuation, really, are you creating this valuation in house? Or better yet, to provide more comfort to the LPAC and the investors, are you going out to a third party valuation service, to evaluate your asset and make sure that the price is fair?

Obviously, it may be at an earlier stage where you're not quite ready to sell, but you want to make sure that there's full transparency and a clear valuation when you do go out to the investors that they're armed with that information before they make a decision on whether to exit or roll.

Chris C: Right. You touched on, I think, a really key point, alignment. That's always what we're going for here. So the GP oftentimes will have to roll a significant, if not entire portion of their underlying interest, often via carry, into the new fund. And I think from just a high level standpoint, that makes sense. Because if you're a GP going out to your current and or new potential LPs and say, hey, we want to continue on investing in this company by setting this new vehicle, if the GP were to take all its money and run, that doesn't really inspire a lot of confidence if you're an LP. So I think that whole alignment topic that you mentioned, Brad, is so key because it shows that, yes, the GP does have confidence in this entity, and we're going to demonstrate that by taking our money, our carried interest that we're entitled to, and parking it in the new vehicle so that we can continue investing in this fund going forward.

And secondary to that, we don't have to sell the company, obviously, to someone else. So the sponsor, the GP can stay as the owner of the underlying company for another however long the fund goes, two, three, four, five years, whatever it might be. So that continuity can be at play here too. So I think that's I'm so glad you mentioned that, Brad. I think that's a huge selling point here.

Chris C: What about the risk to the LPs? Right? Because when you're investing in an underlying fund, that has its own profile. There's multiple companies in it. Whereas a continuation fund could be as few as one company or maybe just a couple.

How should a LP consider the risk ramifications there about whether or not they want to get into what potentially could be a riskier investment since it's only one or limited portfolio companies?

Brad A: Right. When you're looking at you know, there was a survey done by Goldman Sachs in 2023, and 42% of the LPs that were asked said that, fund financing structures like continuation funds or NAV loans, they they interfere with the LP-GP alignment. At least, you know, at that point in time, there was a lot of concern and from their side about, you know, the alignment of interests, the value to them.

And a lot of that, I think, goes to a few different factors. When when they're first proposed, when they receive a proposal from a GP to either exit or roll into a secondary transaction, you know, you want to make sure as an LP that you're given all the information as well as you have enough time to digest that information.

So from their perspective, especially in buyout funds, larger funds where it's allowed institutional investors, they have a process that they need to follow. It's not as easy as overlooking a quick deck and making a decision in a day. They may have an investment committee that they need to go through and to determine, are they going to continue their commitment to this continuation fund? Are they going to increase their commitment? Or do they want to exit and get liquidity?

So making sure that from the GP's perspective that the GP is providing to them transparency around the rationale for the investment, the valuation for it, the new timeline, what is the new structure of the fund going to look like, how much is it going to differ from the existing fund that they already agreed to. LPs have done all their diligence on this one manager, and now they're trying to do diligence instead on a single asset, or a few smaller, more focused group of assets where, you know, there's more concentration risk there.

Granted, it may have already sat in the portfolio for a few years now, so it could be a well known understood asset, especially by the LPAC who've been involved in the valuation process to that point, but it's still more focused. You know, the cash flows are going to be a little less consistent than from a blind pool of investments that you may be receiving frequent distributions in the later stage of the fund.

So you want to make sure that, you know, there's risk there you know, putting your eggs into a single basket, but there's also risk from making sure you understand what the GP is doing, making sure you understand, you know, how they're considering the economics with management fees, with carried interest.

How is that going to change or not change from how it was set up in the existing private equity fund?

Chris C: Right. And I know in our experience here at GPFS, in the continuation of funds we've seen, those mechanics that you touched on are oftentimes, especially for the newer investors, a little more favorable. So, like, so for example, these typically have a tiered waterfall where you might get 10% of carry if you meet certain MOI and IRR metrics, and then 15% at a higher threshold, 20% at something on top of that. That's just, of course, you know, one example, but it is something we've seen with these multistage or tiered approaches to carry to further entice LPs to kind of come in on that as well. And same thing with the management fee, whereas in a traditional fund, you might see us 2% at least during the investment period and then a wind down on invested capital. Oftentimes here, the management fee is much less than that. It might be 1% based on invested capital, for example, some of the ones that I know we've seen.

So big picture here now. The GP goes out. They want to do the fund. The LPs, they typically are given about 30 days is what ILPA recommends to decide whether or not they want to invest.

We've set up the mechanics. Now the fund's ready to go live. What about the expenses on these? Right? Because you've got both new investors coming into the fund. You've got investors coming over from the underlying. How do those get divvied up between the two different groups of investors?

Brad A: Yes. It's a great question. When it gets into the back office logistics and the reporting for these entities, especially as an investor, an existing investor who may be rolling their investment over or a new investor coming into the continuation fund vehicle. You want to make sure that you understand what the fee drag looks like.

And you may have several different categories of investors depending on how the transaction is structured.

You are creating a brand new vehicle now with a continuation fund that will need onboarding, legal costs, compliance costs, administration, audit, all of the tax preparation, all of those things. So now you're adding a whole new entity to the structure. And it's really key that, you know, when I mentioned arming the LPs with information that they understand, how are all those fees and management fees well, how is all of that going to be handled?

How are the expenses going to be allocated between is it something where the new investors will only be responsible for the expenses related to the new entity, whereas the existing investors may only deal with the expenses of the existing fund and the rolling investors somewhere in between some combination of the two, and as well with the carried interest. That's, you know, something that is very concerning to the LPs from the alignment standpoint, making sure that if you are now taking this one asset that may have accrued interest in the existing fund, rolling it to a new fund, how does the carried interest work?

I want to make sure that, you know, the GPs that are putting the same amount of attention to this new, to the asset, in this new vehicle. So as a limited partner, I'd much rather see that the carried interest get rolled into the new vehicle, whereas from the GP's perspective, they may want to use it as an opportunity to reset the allocations of carry at the general partner level. They may have employees and deal professionals who are no longer part of the deal in the continuation phase. So they may want to reallocate the points and how they allocate that.

And then, Chris, you've had plenty of experience with the general partner vehicles.

So allocations and understanding that, you know, as a general partner and as a limited partner, there's transparency between each other. And then from a back office perspective, that there's clarity from the administrator, legal counsel, and tax consultants that there is full transparency around how the fees are going to be allocated is key. If there's an SEC examination, you want to make sure that all of your ducks are in a row and making sure that everything's clear and that you have a good plan ahead of time is critical.

Chris C: Right. So we've spent, you know, most of this discussion talking about the GP and LP side of things, rightly so, since they're the ones doing the work and investing. But you just mentioned it's important to have your legal docs in good order. So the legal team needs to be aware of exactly what you're doing so it can be papered correctly. And then tax, audit, accounting, they need folks like us need to have an understanding of how these all work too so we can properly administer everything here and make sure everything is getting allocated correctly because as you've just so eloquently pointed out, Brad, a lot of the mechanics are more nuanced than in a traditional fund. We have many more unit economics for different types of investors, and understanding how to sort through that is, expertise is going to be essential in order to properly report on this.

Chris C: So given how we're kind of looking at the big picture here, is there anything else that either LPs should be considering when deciding whether or not to come in, GPs whether or not they want to offer one of these products? Anything we haven't touched on that you think would be important to note?

Brad A: I think just overall, I think it's keeping in mind that a secondary transaction, a continuation fund, NAV loans, dividend recaps, these are all tools that a general partner has at its disposal to be able to maximize value for its investors. And that really should be the goal, making sure that we are maximizing the value for our investors, for ourselves, through our investors and making sure that we want the general partner will want to make sure that they're using this as an opportunity to build a stronger relationship with their LPs. And it's something where when I cited that survey as far as the poor reaction to some of these types of transactions, I think a lot of it is the lack of transparency and a lot of, maybe bad faith operations by certain GPs where they are, using it for bad assets when, really, you should be using it as an opportunity to provide flexibility to your investors, not leveraging their need for liquidity and making sure that you're transparent and and partnering with them, you know, every step of the way, that you are making sure that your interests are aligned and that the conflicts are also well thought out and making sure that, like you had mentioned earlier, the GP is sitting on multiple sides of this transaction, both at the existing fund, the new fund, and the portfolio company level.

So there will be plenty of opportunities, or I should say, plenty of situations where you may run into a conflict of interest, and it's important for those conflicts to be addressed early on, and discussed with the LPAC or the investor base and making sure that if any conflicts need to get cleared or further, that it that that you don't dance around it, that you get ahead of it and make sure it's discussed early on.

Besides that, I think just, yeah, making sure that you're being very clear around the unit economics. You're going to have an existing fund that's winding up, a new continuation fund that's starting, so you'll have to handle distributions as well as new capital coming in. How do you treat, possibly crystallize your carry before the sale is finalized. You know, all of those things, it's making sure that from a back office perspective, you're surrounding yourself with experts and people who have gone through these types of transactions before, and that you make sure that you're all on the same page as far as the intent of the agreement, the intent of, any nuances in the transaction and making sure that all of the reporting is properly tracked and all of the tax reporting, your gap reporting, compliance reporting, all of those different areas are covered.

Chris C: Yeah. That's that's a great summary, Brad, because I think one thing that is for sure, these products are going to continue to be offered. And just a couple of quick stats on it. The secondaries market has grown substantially in recent years as we touched on at the start too, in large part due to this GP led deal.

So for example, GP-led transaction volume was about $26 billion in 2019, and by 2022, it had doubled to more than $52 billion. That's according to Jefferies.com. And now the secondary market, over 50% of the ones being offered are GP led in the last few years, up from 24% as recently as 2019. So these products are going to continue to be offered. As we've talked about today, there's opportunities for both the GPs and the LPs to offer these, understanding all the risks, the complexities that go into it for the investors, as well as for the folks on the support side, such as us here at GPFS.

Understanding these bespoke unique funds is going to be essential to providing great reporting in the future.

That's all we have for today. We certainly hope you enjoyed the discussion Brad and I had around these continuation funds. And should you have any questions or comments or want to speak more about it, please feel free to reach out to us here at GPFS. We're always happy to explore any opportunities or address any questions you may have. So thanks for listening to the GPFS podcast. I'm Chris Calogero.

Brad A: I'm Brad Aperance.

Chris C: And hope you have a great day.