United States: To be Continued (or not)
By: Yasho Lahiri
Continuation funds exist because closed-end funds are better suited to a perfect world than an imperfect one.
In a perfect world, as a closed-end fund nears the end of its term, the few remaining portfolio companies the fund owns are ready for sale at attractive prices. The sales happen. Proceeds from the sales wind their way through the fund waterfall to grateful limited partners and successful sponsors. The fund is wound up just as its term comes to an end.
Unfortunately, the real world is imperfect. Portfolio companies may need additional capital to maximize value and, once a fund’s investment period is over, the ability to call capital for this purpose is usually limited. Markets may be choppy near the end of a fund’s term, with asset sales possible only at unattractive prices. Either or both of these realities are all too common for private equity funds in recent years.
Some – indeed, many – say that a continuation fund is the perfect solution. A continuation fund allows investors in an existing fund to retain their upside in portfolio companies, if they so choose, and to provide additional capital for further growth in the portfolio company, often together with third parties who are not investors in the fund. On the other hand, fund investors who want to exit the portfolio company can do so, and their interests in the portfolio company are bought out by the continuation fund.
Are continuation funds a magic bullet? Sometimes they are, but the fact patterns are always complex, and the ideal solutions inevitably bespoke. We wrote an article explaining the issues which can be read here.
The trade press is keenly interested, and one of the better articles on the topic was recently published here. As is usually the case, where the market goes, the SEC will follow; one portion of the recent SEC rule proposal for private funds relates to fairness opinions issued in connection with the establishment of continuation funds:
Where will this all lead? As in the movies, we hope it leads to a fairytale ending.