The use of continuation funds (CFs), vehicles established by a financial sponsor to acquire one or more assets from an existing vehicle operated by the same sponsor, is surging globally. In 2024, CF transactions reportedly exceeded $100 billion worldwide, with the number of deals rising by 48% compared to the previous year. Despite macroeconomic and geopolitical headwinds, all signs point to another record year for the CF market. While the CF market in Australia remains relatively small, it is developing rapidly.
As private capital markets mature, both sponsors and investors are looking beyond historical three to five year holding periods because businesses often benefit from longer term plans and investment. This is fuelling the expansion of CFs, which can deliver the following benefits:
Tailored liquidity solutions: provide tailored liquidity solutions for existing investors by allowing them to either cash out or roll over at the end of a fund’s fixed term. This allows portfolios to be rebalanced and de-risked.
Extended value creation: enable sponsors and rolling investors to retain high-quality assets that have not yet reached their full exit potential, facilitating further value creation beyond the original fund term.
Access to secondaries: offer increasingly sophisticated investors access to mature, pre-identified companies, meeting the growing global demand for secondaries. G+T has experienced greater secondary than primary fund capital pools of late.
Gilbert + Tobin has advised on most CFs in the Australian market, including the MotorOne CF for Quadrant and the recent multi-asset CF for Armitage Associates. This article explores how CFs can align the interests of sponsors and investors, the strategic opportunities they present for stakeholders, and the outlook for the Australian market.
Aligning sponsor and investor interests
Sponsors act as fiduciaries for both the existing fund and the new vehicle, and must balance the interests of selling, rolling and new investors when negotiating CF transactions. This dual role carries potential - or at least perceived - conflicts, making the alignment of interests a critical factor in the success and continued growth of CFs. As the CF market has matured, transaction terms and processes have been honed to address these dynamics.
Several commercial and legal mechanisms – focused on transparency of processes and fair treatment of investors – are being employed to achieve this alignment. Best practice in this area continues to evolve, with the Institutional Limited Partners Association (ILPA) in the U.S. issuing guidance in 2023 (ILPA Guidance). While most of these recommendations are being widely adopted, CF transactions remain highly bespoke, and the ILPA acknowledges their guidance may not be applicable in every case. It should also be noted that ILPA represents investors, and its guidance generally goes beyond what is considered ‘market’ globally.
Key mechanisms for achieving this alignment include:
Investor engagement: all existing fund investors should be given full disclosure and transparency about the transaction (including the rationale for pursuing a CF over alternative options, the terms of the sale and the terms of the CF) as early as possible. ILPA Guidance suggests a minimum of 20 business days for review, enabling investors sufficient time to decide whether to cash out or roll their interest into the CF. Sponsors should also ensure there is consistency of information between existing investors and new investors.
IAC approval: CFs typically constitute conflict transactions under fund documents. Approval from the existing fund’s Investor Advisory Committee (IAC) is usually required for all conflicts relating to the transaction process and economics (including the crystallisation of carried interest, the method of soliciting bids, and any economic incentives accruing to the sponsor). ILPA recommends that IACs are given ample time and information to evaluate and approve all conflicts.
Rolling investors: investors who roll into the CF should see the terms of their existing fund side letters carried over, with no increase in management fees or carried interest, to ensure they are no worse off than if the CF transaction had not occurred.
Valuation: the pricing of CF transactions has received significant focus. The ILPA Guidance recommends an independent valuation or a competitive third-party bidding process. Where there has not been a recent price discovery exercise, it is increasingly common for the sponsor to run a competitive process for the CF assets. Going further than the ILPA guidance, the U.S. Securities and Exchange Commission (SEC) adopted new rules in 2023 (SEC Private Fund Rules) that require sponsors on CF transactions to obtain either a fairness opinion (confirming the sale price is fair) or valuation opinion (confirming the value of the assets being sold) from an independent valuer. More recently, the Financial Conduct Authority in the U.K. has also recommended obtaining independent fairness opinions. G+T’s experience is that independent valuations and opinions may ‘tick the box’ but often do not provide much additional comfort to investors. This is because such valuations and opinions often have ranges based on numerous assumptions (which may or may not be accurate), whereas the sponsors and lead investors into the CFs tend to have a better understanding of the underlying business and its market value. Ultimately, the transactions will occur at the price that incoming investors are willing to pay - not at what they are valued at on paper.
Carried interest: new and rolling investors expect sponsors to retain significant ‘skin in the game’ by either rolling a substantial portion of their carried interest and/or increasing their equity commitment to the CF. The ILPA Guidance goes further, recommending that there is no crystallisation of carried interest for rolling investors, and that all carried interest related to selling investors be rolled into the new vehicle. This was the most controversial of the recommendations made by the ILPA and does not reflect market practice in Australia. G+T has observed that CF transactions to date in Australia have all entailed strong conviction from CF sponsors which has resulted in those sponsors rolling their carry and, in some cases, making additional investments.
Strategic opportunities for stakeholders
Provided that sponsors can successfully navigate the complex web of conflicts to successfully align investor interests, CFs offer a range of strategic opportunities for stakeholders, including:
Alternative exit paths: giving sponsors a viable exit option alongside IPOs, secondary buyouts and trade sales. They can be flagged as a liquidity route at the outset of a sale process, helping to de-risk such processes and apply pressure on bidders to bridge valuation gaps. While CFs may not attract outlier bids, in volatile M&A markets, they do provide investors with fair pricing and execution certainty, while offering rolling investors the potential to maximise value on a future exit.
Extended turnaround time: for assets that are distressed or require a longer holding period to realise their full potential, providing additional turnaround time beyond the original fund term and avoiding forced sales at sub-optimal times.
New asset strategies: enabling sponsors to implement new strategies for assets – often involving bolt-on opportunities, recapitalisation with fresh equity, and/or debt refinancing (sometimes with a dividend recapitalisation).
MEP re-set: better aligning management teams with the revised asset strategy for the CF by establishing new incentive structures - particularly where the transition to a new fund triggers the crystallisation of existing management equity plans.
Expanding investor base: allowing sponsors to broaden their investor base by attracting sophisticated secondary investors who are well equipped to navigate the complexities of CF transactions. Successful CF transactions can also enhance a sponsor’s reputation for alignment and transparency, supporting future fundraising efforts.
Strengthening existing relationships: encouraging sponsors to maintain strong relationships with existing investors, increasing the likelihood of their support for the CF transaction and their participation in the next phase of the asset’s life cycle.
Outlook for Australia
Given the opportunities presented by CFs, G+T expects that they will see continued mainstream adoption in the Australian market. As their use grows, several trends are emerging:
Structural innovation: the CF market is evolving to meet the specific objectives of sponsors and investors. As traditional M&A mechanisms are adapted for CF structures, deferred payments, performance-based earn-outs, and W&I insurance (as security for the buying fund’s protections), are likely to be increasingly used.
Multi-asset funds: multi-asset CFs are expected to become more prevalent, particularly where sponsors hold several quality long-term assets and new investors look to deploy more capital on investment and seek to mitigate concentration concerns.
Broader asset classes: while CFs have been most common in traditional private equity and venture capital funds, they are expanding globally into infrastructure, credit, real estate and other funds. Part of this is being driven by the desire to continue to hold quality long-term assets.
Greater investor sophistication: as the CF ecosystem matures, both outgoing and incoming investors are becoming more sophisticated in their approach. The rise of specialist CF-focussed investors is expected to drive further demand, and these investors will likely exert greater influence over terms and processes.
Increased regulatory scrutiny: regulators have been increasing their scrutiny of CF transactions. More data and performance feedback, especially after adopting ILPA Guidance and the 2023 SEC Private Fund Rules in the U.S., may ease regulators’ concerns if most CF transactions show good governance and active investor involvement.
CFs can be complex. Each CF transaction requires careful planning and management of the process from the outset to tailor the transaction to, and balance the needs of, all stakeholders. When this is done right, all stakeholders win.