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Continuation Funds: A View from North of the Border

Elizabeth Dylke and Gordon Nyman Cameron

Continuation Funds: A View from North of the Border Perugini

Private Equity (PE) sponsors, typically led by the general partner (GP) of a PE fund, historically used so-called “Continuation Funds” as a portfolio management tool of last resort when managing underperforming portfolio investments of an otherwise successful fund. Today they are proving to be an exit of choice for investors and sponsors alike. We are now seeing GP-led secondary transactions, in the form of Continuation Funds, used frequently as an attractive solution for liquidity in a market where conventional exits and portfolio company valuations are uncertain. Secondary market volume was USD $115 billion globally in 2023 (42% of which consisted of GP-led transactions) with the secondary market demonstrating significant resilience since 2021 compared to a volume decrease in IPOs, private equity exits and the private M&A market. As opposed to a mere holding vehicle for distressed assets, Continuation Funds are now utilized as a structuring solution to extract further value from well-performing investments that have yet to reach their full potential and relieve the pressure to sell a stable performing asset in scenarios where fund investors are happy to hold assets for a longer term.

Structure. The PE industry is now familiar with the structure of a Continuation Fund that is used for performing assets, which involves the formation of a new fund by a PE sponsor for the purpose of acquiring one or more performing assets from an original fund managed by that same PE sponsor. Limited Partners (investors) in the original fund are given the option to either roll their existing interests into the Continuation Fund or cash out of the original fund and exit. Interests in the Continuation Fund are then offered to “new money” investors who make cash contributions to the new fund which are used in-turn to cash out the original fund investors that have opted to sell.

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Canadian Issues. As Canadian lawyers we are frequently asked to advise U.S. PE funds on Canadian transactions and legal issues related to cross-border transactions, fund formation and fundraising activities. While Continuation Funds are still rare among Canadian PE sponsors compared to U.S. PE sponsors, there are no shortage of Canadian issues that arise given the amount of Canadian capital invested with U.S. and European PE sponsors. Bennett Jones recently acted as Canadian counsel to a U.S.-based private equity fund managing approximately USD $80 billion in assets in connection with two Continuation Fund transactions (one in 2021 and the other in 2023). Each transaction involving the transition of a portfolio of European and U.S. assets valuing ~USD $2 billion. Given the various Canadian institutional investors and capital invested in each of the original funds, the PE sponsor was compelled to consider Canadian regulations at play in using a Continuation Fund structure to retain valued assets. This included Canadian securities offering rules and securities regulations that would be triggered in Canada by Canadian rollover investors and the new Canadian investors participating in the Continuation Fund.

Certain tax efficiencies were realized through the use of Canadian vehicles. To take advantage of certain tax treaties requiring the need for a non-U.S. domiciled special purpose vehicle, the U.S. PE sponsor in these two transactions chose to engage the Province of Ontario as a jurisdiction to form the acquisition vehicle for certain European assets. In scenarios where tax efficiencies are equivalent to traditional tax haven jurisdictions such as the Cayman Islands or Luxembourg, Ontario has proven to be a good choice given its simple registration framework and perception as a “friendly” and “safe” jurisdiction for U.S. connected deals. Ontario limited partnerships can be formed quickly on the basis of a simple filing that discloses only the GP and its address. No summary of partnership terms or list of limited partners is required. The anti-money laundering requirements are not onerous and once the entity is formed, the Canadian regulators tend to leave sponsors alone.

Common Hurdles. The PE industry is also becoming all too familiar with the unique issues presented in Continuation Fund transactions and the growing experience with these types of deals has provided much opportunity for troubleshooting. The inherent nature of Continuation Funds requires the GP to manage inevitable conflicts of interest resulting from the GP being on both sides of the transaction. On one hand, the GP must meet its duty to act in the best interests of existing investors by achieving the best value for the assets being sold by the original fund. On the other, valuation of the transferred assets will have an impact on the GP’s carried interest in the new fund. For this reason, achieving a fair valuation is vital to the integrity and reputation of the PE sponsor. If the GP can strike a price that is high enough to provide exiting investors with a sense of good value, but low enough to attract new investment in the continuing assets, then theoretically it can be a win-win situation for all. From a process perspective, Continuation Fund transactions can also be challenging. Managing conflicts and valuation-based approvals often make the negotiations more cumbersome than in a traditional M&A transaction. If the sponsor can run a streamlined and transparent process, it may be that in a period of market uncertainty, GP-Led Continuation Funds will become a preferred method of exit for investors.

Managing Hurdles. The more common use of Continuation Funds has allowed the industry to develop tools which can be employed to ensure a smooth transaction. In May of 2023, The Institutional Limited Partners Association (ILPA) released guidance on Continuation Fund best practices, which included recommendations of full transparency and a strong role for LP Advisory Committees to oversee conflicts and valuations. From a practical perspective, setting realistic and achievable timelines will give the transaction credibility and mitigate a possible tendency for investors to get frustrated or have second thoughts in a drawn-out valuation, funding and closing process. A measured approach that involves engaging investors as early as possible and well before the election date required to opt into the new fund while providing them ample disclosure of information will give investors a sense of confidence in the deal. It should also relieve investors from the pressure that inevitably comes from having to make quick decisions on whether to stay or go. In addition, with respect to deal terms of the new fund, GPs are expected to also participate and keep their money invested in the new fund as the more “skin” the GP has in the game, the more likely there is to be a sense among rollover and new money investors that their risk-reward rationale for the transaction is aligned with that of the sponsor’s.

Looking Forward. From North of the border we are looking forward to the various ways in which Canadian players will continue to participate and shape the secondary market. We expect the volume of successful GP-led transactions to continue to provide liquidity solutions for investors and opportunities for PE sponsors to nurture value in mature assets.