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E-MailKobi Kastiel is a Professor of Law at Tel Aviv University and Yaron Nili is a Professor of Law and Smith-Rowe Faculty Fellow in Business Law at the University of Wisconsin Law School. This post is based on their article forthcoming in the University of Pennsylvania Law Review.
The private equity business model has reinvented itself over the years, with continuation funds now serving as its latest development. These funds offer a creative solution to circumvent the constraints of the traditional private equity model by enabling fund sponsors to retain assets beyond the customary 10-year fund term. In the past, funds’ investments were expected to be liquidated once the fund term lapsed. With a continuation fund, instead of liquidating an asset that has not yet realized its full potential and selling it to third parties, the same fund sponsor sells this asset to the newly established fund. Limited partners (LPs) that invested in the legacy fund can either roll their interests into the continuation fund or exit. For new investors, continuation funds offer the opportunity to invest in more “mature” and visible assets and to reinforce their relationship with the sponsor. For these reasons, supporters of continuation funds view them as a “win-win-win” for all parties involved.
Continuation funds are not an esoteric phenomenon. In the past few years, they have grown increasingly popular within the private equity space, and are now the most common type of secondary transactions led by private equity sponsors. In 2021, these transactions reached their highest volume in history, estimated at around $65 billion in deal value, representing a 750% increase since 2016. According to market experts, these funds are here to stay and to grow.
Despite their surging popularity among private equity sponsors, continuation funds face unusual investor resistance. The Chief Information Officer of Europe’s largest asset manager went so far as to claim that certain parts of the private equity industry look like “Ponzi schemes” because of their “circular” structure, tossing assets back and forth. Another leading pension fund executive warned that private equity groups are increasingly selling their companies to themselves on a scale that is not “good business for their business” (see here and here). The Securities and Exchange Commission (SEC) has not remained indifferent to this important market development. In August 2023, it approved new rules that, among other changes, were aimed to provide a check against a sponsor’s conflicts of interest in structuring continuation funds. Just recently, the fifth circuit ruled in favor of six private equity and hedge fund groups that challenged the regulations leaving the private equity regulatory landscape murkier than ever.
These general concerns, however, leave some crucial questions open: What types of misalignments of interests might continuation funds cause? How severe are these conflicts? What are the economic interests of the sponsors? Why do most investors decline the option to roll over their stakes into the continuation fund, even though it is run by the same sponsor they have trusted with their investments up to that point? Do these investors have the power to fend for themselves or is regulatory intervention required and how effective are the existing regulatory and market mechanisms in addressing continuation fund conflicts?
Despite the growing impact of continuation funds on the U.S. and European capital markets, no academic study has closely examined these questions. Our recent Article, forthcoming in University of Pennsylvania Law Review (2024), fills that gap.
We make three key contributions to the existing literature. First, we provide a systematic analysis of the web of conflicts continuation funds generate. We show that continuation funds guarantee substantial benefits for sponsors, including additional management fees, an option to receive an additional carry in the future (or to earn carry on previously non-qualifying investments), an opportunity to control the fund’s assets for a longer period, and in the case of early-stage continuation funds, the benefit of a fast crystallization of carried interest.
However, in continuation funds, sponsors place themselves in a position where they are committed to two groups of investors whose interests are in direct conflict—the exiting investors interested in selling the fund’s assets at the highest possible price and the incoming investors in the continuation fund interested in paying the lowest possible price for the assets. The tendency of most existing investors (80–90%) to cash out instead of rolling over their investments intensifies the severity of this conflict. Assessing how this conflict unfolds in practice is challenging due to data limitations. While in theory one group of investors (sellers or buyers) could sometimes have the upper hand—and sometimes the lower hand—our analysis suggests that the sponsor almost always wins.
We also show that sponsors’ incentives to establish the continuation fund and the close relationships between the sponsors and the new investors in continuation funds, often sophisticated and repeat players specializing in secondary transactions, might lead sponsors to favor new investors’ interests over those of the legacy fund investors electing to cash out. Recent empirical evidence supports this view. We further explain how investors in the legacy fund may face losses on two fronts: they can no longer rely on the sponsor as their faithful agent in the transaction’s negotiation, and they lose exposure to the assets if the continuation fund proves to be a successful investment.
This web of conflicts not only results in distributional effects but also imposes efficiency costs. Sponsors’ strong financial interest in establishing continuation funds could lead them to forgo better exit options, resulting in suboptimal utilization of investors’ capital. Continuation funds also enable fund sponsors to retain assets beyond the customary ten-year fund term and exacerbate the information asymmetry problem in the private equity industry.
Second, we utilize qualitative data from interviews with market participants from both sides of the transaction––investors and sponsors––to provide a more comprehensive analysis of continuation funds’ dynamics. There is a certain level of secrecy surrounding continuation funds: researchers often do not have access to the original limited partnership agreements or these funds’ valuations, which are regarded as a “black box.” To overcome these informational limitations, we conducted interviews with leading market participants who all had first-hand experience with continuation funds, and together participated in over eighty-five continuation fund transactions totaling over $60 billion in 2022.
Using interviews and other publicly available resources, we explain how examining continuation funds can help clarify two key aspects of the private equity landscape. One is the notion that investors’ sophistication enables them to protect their interests. We show how informational disadvantages, lack of expertise, lack of time, diversification and liquidity considerations, and internal agency problems of institutional investors often force investors to sell their stakes under unfavorable conditions. A recent survey supports this analysis, showing that a small minority of all investors express significant interest in continuation funds. We also examine the convention that, in an industry in which investors rarely use litigation to enforce their rights, non-legal incentives are sufficient to maximize value for all parties involved. We highlight the limitations of this theory, particularly regarding less sophisticated LPs with limited bargaining power.
Third, we discuss the shortcomings of the SEC’s regulatory approach, which has focused on the mandatory use of fairness opinions, as well as other mechanisms used by market players to solve continuation fund conflicts (such as subjecting the initiation of these funds to the approval of a limited partnership advisory committee, requiring the sponsor to reinvest its profits into the continuation vehicle, and using a competitive bid). Based on insights from our interviews, we explain why these mechanisms are unlikely to cure the structural biases generated by continuation fund transactions. Against this backdrop, we also offer a set of policy recommendations directly addressing the misalignment of incentives between sponsors and investors.
The study of continuation funds is an important setting for examining the power dynamics in the private equity industry, particularly the differences in sophistication and bargaining power between various players. It also sheds light on the institutional and agency problems many investors face, their limited power to mitigate sponsors’ conflicts, and the limits of reputational markets in an industry lacking extensive disclosure and regulation, or any effective underlying threat of litigation.
The Fifth Circuit decision vacating the SEC rule suggests that the complex issues that continuation funds present will continue to remain on the agenda of investors, practitioners, policymakers, and academics. In that regard, we are especially encouraged by the increased attention to, and active discourse around continuation funds that is emerging in response to our study.
The full Article is available here.
