Continuation funds: a difficult exercise in dealing with conflicts of interest

Is the playing field for private equity managers about to end? This summer, as part of its reform of the Advisers Act, the US Financial Industry Regulatory Authority focused its attention on conflicts management in continuation funds, vehicles set up on an ad hoc basis to support one or more investments over the long term. “We continue to believe that the requirement for third party verification of valuation is an essential element in preventing the type of harm that could result from a conflict of interest in the structuring and execution of a secondary transaction.” With these words, the Securities and Exchange Commission (SEC) has mandated the systematic use of fairness opinions on price by independent third parties.

Given the difficulty of exiting the market, continuation funds flourished. According to the latest Greenhill & Co. report, they accounted for more than 83% of so-called GP -led deals in the first half of 2023. This secondary mechanism allows managers to set up their own fund with existing or new investors (limited partners, LPs) and transfer one or more holdings to it to continue supporting the assets.

And because the general partner (GP) sells the assets to itself, it must deal with managing conflicts of interest and setting the resulting asset price. While US regulators have been scrutinising the complex issue of managing conflicts and setting prices for hedge funds, French managers still seem to enjoy a certain reprieve without having been the subject of such regulatory attention so far.

Several safeguards

“At the moment, each manager acts on its own discretion in the French and European markets, but the situation could change with regulatory developments in other countries,” says a lawyer who advises investment funds. There are a number of safeguards to overcome and manage the conflicts inherent in this secondary mechanism. From setting up separate teams to using fairness opinions, fund managers have several options to safeguard themselves.

To reassure investors, parties can agree to an independent valuation of the portfolio of assets sold in the form of fairness opinions. But “while the use of fairness opinions is common practise in the US market, it is much rarer in Europe,” explains Stéphane Vanbergue, partner at Eight Advisory. These fairness opinions have “much less probative value than a third party co-investment and say nothing about the value that an external third party would be willing to put on the table,” he explains. In Europe, the focus is more on due diligence: “In the transactions we have been involved in, there has systematically been a comprehensive due diligence of the seller, equivalent to the level of a sale to a third party,” he notes in practise.

In other cases, the fund manager may set up a classic competitive auction process to determine a fair price, with the going concern fund being one of many bidders. Finally, as buyout funds become more common, fund managers are beginning to include this secondary scenario early in their financial documentation. For example, change of control clauses include the event that the asset is sold by a going concern fund.

For the time being, however, all these solutions are not yet binding. This secondary mechanism has a number of shortcomings and raises questions.

The credibility of NAV is at stake

Net asset value (NAV) is an important indicator and part of the reporting that fund managers produce on their portfolios. “The fact that a fund manager can potentially

A manager can potentially propose a different price from NAV in the context of a going concern fund raises questions about the credibility of NAV,” says a Paris-based corporate lawyer. LPs risk losing confidence in the NAV set up by GPs”. A discrepancy between the proposed price and the NAV may also jeopardise the success of the continuation fund: “There have already been several unsuccessful transactions due to the discrepancy between the proposed price and the NAV”, he continues.

This problem of price determination is even more complicated in certain sectors. “This problem is exacerbated in the context of illiquid real estate investments, where the actual price available on the market may differ from, and in many cases be lower than, the fair market value of the asset(s) reported to existing investors,” says a report by law firm Allen & Overy entitled “Continuation funds for real estate fund managers”.

Risk of overstepping

Against the backdrop of difficult exits, some managers may succumb to the temptation and consider this mechanism mainly with the aim of generating liquidity for investors and increasing carried interest.

“Faced with complex exit situations, managers may be tempted to opt for continuation funds for low-potential assets with little growth potential. However, these approaches generally have little chance of success,” points out Stéphane Vanbergue. “Such mistakes can be very costly for a fund manager and affect its ability to raise funds in the future, especially in an environment where fundraising is becoming increasingly difficult and past fund performance is under scrutiny,” he continues.

While the risk is there, it has not materialised in practise. And for good reason. “There is so much at stake, especially when it comes to managers’ reputations, and managers have the ability to extend the holding period of an asset, that it is unlikely that a manager would choose a going concern fund to divest an asset that is not very promising,” agrees one market lawyer. That should reassure investors.