ILPA Publishes Guidance on Continuation Funds

Due to the complexity of these transactions and the broad range of continuation fund deals, ILPA acknowledges that the guidance may not be appropriate for all transactions but states that it is “intended to provide general parameters for well-run processes that will encourage productive dialogue and foster more informed decision-making by LPs.”

Many of the suggestions in the guidance will be familiar to private fund sponsors (GPs) and are already included in their continuation fund processes. However, it is important for market participants to review this latest guidance and consider whether any additional actions are advisable.

Furthermore, GPs that are registered with the US Securities and Exchange Commission (SEC) should expect additional scrutiny on continuation funds, including in relation to: (i) their presence on the SEC’s examination priorities for 2023;¹ (ii) the newly adopted quarterly reporting requirement on Form PF for advisers to private equity funds;² and (iii) the expected new rule on “adviser-led secondary transactions.”³

The full guidance document can be accessed via ILPA’s website, and the main themes are outlined below.

Role of the Limited Partner Advisory Committee (LPAC)

ILPA suggests that all conflicts associated with continuation funds be mitigated by the GP and approved by the LPAC, and that any anticipatory continuation fund language in LPAs should not include a presumptive waiver of conflicts.

The guidance also makes recommendations as to how the LPAC could be further involved, such as being consulted at an early stage on the rationale of the proposed transaction, reviewing the GP’s selection of adviser (including the terms agreed with such adviser, such as compensation), and carrying out a review of the terms of the entire deal with the GP no less than 10 business days prior to the signing of the acquisition agreement.

It also suggests that it may be appropriate for the LPAC to have access to independent legal or other advice (paid as a fund expense), particularly on more complex transactions.

Transparency for all LPs

While the LPAC has an important role to play in a continuation fund transaction, the guidance also states that all existing LPs should, at an appropriate point, have parity of information with the new investors and the LPAC, while respecting any commercially sensitive information. GPs should grant all existing LPs data room access and provide sufficient information and time to complete their due diligence.

ILPA also suggests that a fairness opinion on the value of the underlying assets may be beneficial to the LPs in certain circumstances. We note that the SEC has proposed requiring such an opinion with respect to each continuation fund transaction even if not requested by LPs.⁴

Elections by Existing LPs

Existing LPs are required to actively engage in each of these transactions in order to decide whether to cash out or roll their interest into the continuation fund. ILPA recommends that LPs should be given at least 30 calendar days or 20 business days to evaluate a transaction and make the necessary election, because investors may need to treat this as they would a new investment and may require investment committee approval. If an LP cannot make the election within the prescribed time frame, the default option should be that they cash out and receive their share of the sale proceeds, as they would if the assets were sold by the fund to a third party.

ILPA suggests that the options provided to LPs should also include a “status quo” option, i.e., an option to participate in the continuation fund on the same headline economic terms as the existing fund. This could present GPs with a challenge in some transactions, for example where there is more than one “existing fund” selling assets to the continuation fund.

Economics

ILPA outlines that for rolling LPs, there should be no increase in management fee basis or percentage, or increase in the carried interest rate, and no decrease in the preferred return hurdle. There should also be no crystallization of carry for rolling investors, and any carry received by the GP from those investors cashing out should be rolled over into the continuation fund, or the GP should provide a detailed explanation as to why it chose not to roll over all the carry received.

Allocation of Fees and Expenses

ILPA recommends clear disclosure of allocation methodology for transaction fees and expenses, and it suggests that the GP should share a portion of transaction costs in cases where the GP benefits from additional fee revenue or a stapled commitment. If there is a broken deal, the allocation should conform with the provisions of the LPA, and costs incurred by the GP to solicit offers after LPAC waiver or approval should be considered a fund expense.

Recommendations for LPs

Interestingly, ILPA has set out certain recommendations to help LPs anticipate a continuation fund process, a clear sign that it believes these transactions will continue to evolve and form an important part of the private funds world. They include establishing protocols for assessing and approving continuation fund deals, working with GPs on expectations around timing and disclosures, requesting materials on the rationale behind the transaction as part of their due diligence, and building in questions regarding possible continuation funds in their due diligence processes for new fund investments.

^[1] See our Client Alert: Private Fund Sponsors Remain in Spotlight of the SEC’s Examination Priorities, available at https://www.goodwinlaw.com/en/insights/publications/2023/02/02_08-private-fund-sponsors-remain-in-spotlight.
^[2] See our Client Alert: New Form PF Current and Quarterly Event Reporting and Expanded Large Private Equity Fund Adviser Reporting Adopted by SEC, available at https://www.goodwinlaw.com/en/insights/publications/2023/05/alerts-otherindustries-pif-new-form-pf.
^[3] See our Client Alert: SEC Proposes Radical Changes to Private Fund Regulation, available at https://www.goodwinlaw.com/en/insights/publications/2022/02/02_09-sec-proposes-radical-changes-to-private.
^[4] See our Client Alert: SEC Proposes Radical Changes to Private Fund Regulation, available at https://www.goodwinlaw.com/en/insights/publications/2022/02/02_09-sec-proposes-radical-changes-to-private.