Key themes and recommendations emerging from ILPA guidance 8 min read
The Institutional Limited Partners Association (ILPA) has released guidance on continuation funds. The guidance, which reflects input from both sponsors and investors, is released amidst the continued deployment of continuation fund structures (also known as General Partner (GP)-led secondaries) by private equity sponsors in an environment where alternative exit options for portfolio company investments remain challenging and where the structuring of continuation funds is attracting interest from regulators globally.
In this Insight, we discuss the key (and in some respects, novel) takeaways relevant to private equity sponsors and Limited Partner (LP) investments teams.
Key takeaways
The following is a summary of the key themes and recommendations emerging from ILPA's guidance:
- Limited Partner Advisory Committees' (LPAC) participation: best practice is to ensure that LPACs vote to waive conflicts of interest associated with a continuation fund transaction. GPs should bring all conflicts to the LPAC, regardless of whether conflicts are pre-cleared under the terms of the fund documents. They should disclose the necessary information about the selected assets, the process, the rationale and details of any bids for assets in a timely fashion to the LPAC when considering conflict waivers, and disclose such information to all existing investors to facilitate roll or sell decisions.
- Valuation: GPs should run a competitive process (including third-party price validation) to ensure a fair price is obtained.
- Timing: LPs in the selling fund should be afforded at least 30 calendar days, or 20 business days, to make roll or sell decisions with respect to the continuation fund transaction. LPACs should be engaged at a significantly earlier point in time and should be provided with all information to make an informed decision in relation to the waiver of conflicts.
- Side letters: the guidance states that rolling LPs' side letters, including all relevant risk and governance terms, should, where relevant, apply to their investment continuation fund.
- Economics: rolling LPs should be no worse off than if a transaction had not occurred (including no increase to the management fee or carry). Controversially, ILPA advocates that there should be full rollover of carried interest into the new vehicle (rather than crystallisation at the point of sale).
Management and mitigation of conflicts
General Partners on both sides of the transaction
When used well, continuation funds can offer a number of key benefits to all parties, including:
- providing liquidity to investors in the selling fund in accordance with the fund life and investment horizon to which the sponsor and all investors have committed; and
- allowing sponsors (and investors in the continuation fund, including existing investors electing to roll their interest rather than cashing out) to retain high-performing assets beyond the fixed-term life of a fund and benefit from continued upside.
However, continuation fund structures, which involve a sponsor selling one or more assets held in an existing fund to a newly established fund which it also manages, and which is established for the purpose of acquiring the transferred investment(s), involve inherent conflicts of interest.
There may also be conflicts relating to existing investors in the selling fund, if they are choosing to roll their interest in the continuation fund and therefore also have an interest on both sides of the transaction – in particular, where they are represented on the selling fund LPAC. The ILPA guidance does not address this particular conflict.
These conflicts need to be managed effectively for the benefits of continuation fund transactions to be both perceived and realised.
ILPA's recommendations on mitigation of conflicts
For wholesale funds, absent any need to amend the constituent fund documents to give effect to the transaction, a sale of one or more assets to a continuation fund is generally regulated by the conflicts provisions of the selling fund documents, given the sponsor will be negotiating (and has an interest) on both sides of the transaction. ILPA seeks to improve industry practices, making the following recommendations:
- conflicts related to the process should be identified, mitigated by the sponsor and approved by the selling fund LPAC, which may include:
- the terms by which there is any crystallisation or acceleration of carried interest;
- the method of soliciting bids on the selected asset(s); and
- any economic incentive accruing to the sponsor, such as stapled financing or changes in the new fund terms which may be favourable (including changes to the preferred return hurdle); and
- any conflicts related to the final economics of the transaction where the sponsor may receive a benefit that does not accrue to the investors should also be identified, mitigated where possible and approved by the LPAC.
Emerging trend of continuation fund pre-clearance clauses
An emerging trend has been pre-clearance clauses appearing in fund documents, which would bypass the LPAC conflict consent process and move the transaction straight to the election decision of investors (via the decision to roll over, redeem or a combination of both).
While argued that this smooths the continuation process by reducing the burden on LPACs, these proposals have received strong pushback from investors, particularly if an election decision may only offer partial liquidity (depending on investor demand to redeem, rather than roll over into the new vehicle, and the sponsor's success in attracting new commitments into the continuation vehicle).
ILPA encourages GPs and LPs to avoid fund terms which seek to pre-clear conflicts associated with continuation fund transactions. We are increasingly seeing fund documents include the approval of sales to a continuation fund as a specifically identified LPAC approval right (rather than relying on approval rights relating to conflicts in general). In addition, we are seeing the preclusion of LPAC members from voting on any such approval where they represent investors who have committed to roll all, or a portion of, their interest into the continuation fund.
Iterative approval process in seeking LPAC approval
As noted above, ILPA's guidance makes it clear that the parties should be afforded sufficient time and information to make an informed decision. In our experience, this is an issue which GPs and LPs alike are alive to – noting that LPACs may ultimately withhold approval of a transaction if the sponsor has provided insufficient or incomplete information (absent a pre-clearance clause). In practice, we tend to see an iterative process which starts early, and which involves a high degree of back-and-forth between the sponsor, the LPAC members and the investors in the continuation fund, with sponsors sounding out investors (and discussing the commercial rationale for the proposed transaction) well in advance of commencing the formal process.
Valuation issues in continuation fund transactions
ILPA's recommendations and our experience in the Australian market
Related to, and a key mitigant of, conflicts in continuation fund transactions is providing investors (both in the selling fund and prospective investors in the continuation fund) with confidence in the robustness and independence of the valuation of the asset(s) being sold. ILPA advocates that sponsors should run a competitive process to ensure a fair price is obtained, but otherwise does not advocate for a particular form of valuation opinion. It does suggest that selling investors in the existing fund may benefit from an independent assessment of the value of the underlying assets and, as a group, may request the sponsor to commission a fairness opinion for the fund, conducted by an adviser independent of the party selected as the sponsor's adviser, with regards to the sale price.
In the wholesale funds market in Australia and outside of a registered scheme context, related party transactions such as continuation fund transactions are not regulated by the Corporations Act 2001 (Cth) or ASIC guidance. That said, this issue is front and centre for both sponsors and investors, and our experience in the Australian market suggests it is reasonably standard practice for the sale price to be supported by an independent valuation and/or a price is set by reference to the outcomes from a competitive sales process (eg where a portion of the asset(s) being sold is sold to a third party, with the remaining portion sold to the continuation fund on the same pricing terms).
Global regulation of continuation fund transactions
There is increased regulatory focus (albeit, to date, offshore) on continuation fund transactions and on valuations in particular. The United States Securities and Exchange Commission is proposing new rules under the Investment Advisors Act of 1940 to regulate continuation fund transactions, including a requirement for regulated advisers to obtain a fairness opinion from an independent expert where a manager offers fund investors the option to sell their interests in the private fund, or to exchange them for new interests in another vehicle advised by the manager, regardless of whether a competitive sales process has been conducted. In our view, adherence to industry-wide leadership on best practice for valuation in continuation fund transactions will reduce the risk of, and need for, further regulatory intervention.
Considerations for LPAC members
A difficult issue for LPAC members in evaluating any continuation fund transaction is the risk of waiving conflicts or approving a continuation transaction where LPs who do not have representation on the LPAC may have little say or consultation on the matter.
ILPA affirms the view (which should also be reflected in fund terms) that individuals serving on the LPAC should have regard to the interests of the LPs they represent and do not owe a fiduciary duty to the fund or to other investors, and LPAC members should be (and, in our experience, are) appropriately indemnified in relation to any decisions made on the transaction.
That said, the LPAC as a whole should work together to achieve a process and terms which maximise value for existing investors as a whole. In this context, ILPA notes that LPACs should ideally have a right to independent advice which is reimbursed as a fund expense. In our experience, the duties of LPAC members is a key issue and one on which we are routinely asked to advise formally on behalf of sponsors (ie as a fund expense) and for the benefit of the LPAC members. However, while not yet a common presence in Australian funds, we have seen the recent emergence in offshore fund documents of caps on the amount of external advice fees the LPAC can claim as a fund expense. This is something LPs should be increasingly mindful of, given that over the life of a new fund, it is conceivable there may be numerous continuation fund exits for the LPAC to evaluate (some or all of those exits warranting the assistance of external independent advice), in addition to other matters in respect of which the LPAC may seek to obtain independent advice over the life of the fund.
Treatment of carry
ILPA advocates that, in almost all cases and to ensure an alignment of interests, the sponsor should roll all accrued carried interest into the continuation vehicle.
In our view, this is an overly blunt instrument to mitigate conflicts issues and ensure the fairness of the valuation price ascribed to the continuation asset – particularly if, as proposed by ILPA and reflective of our experience of market practice, the LPAC is afforded sufficient time and information to assess the transaction, there is independent validation of the sale price and the LPAC is afforded an opportunity to make a determination on whether or not to waive the conflict issues. A balance needs to be struck across a range of considerations, including:
- the length of the hold period for assets in the origination fund (which is something the sponsor and all investors commit to during the fundraising process);
- the structure and terms of the sponsor's incentive arrangements (particularly where they are based on whole-of-fund rather than asset-by-asset performance);
- the process deployed to validate the price for the continuation asset; and
- the structure and terms of liquidity available to existing investors in the origination fund.
If ILPA's proposal was to become the industry norm, it would significantly disincentivise management teams pursuing continuation fund transactions, and in the process deny investors the many benefits of such transactions.
ILPA's suggestion that 100% of accrued carry (including in respect of selling investors) should be rolled into the new continuation vehicle adds a further layer of complexity (and potential uncertainty) to both (a) the structuring and operation of carry clawback mechanisms in respect of the selling fund, and (b) the right and entitlement of the sponsor to carry in the continuation vehicle, to the extent it is referable to investors which have exited, and is a significant departure from current market practice in Australia.
What's next?
ILPA's most recent paper builds on its 2019 guidance and provides an additional layer of prescriptive guidance on best practice for disclosure of information to investors and LPACs and conflicts management. Aside from ILPA's views on the treatment of carry (discussed above), in our experience ILPA's guidance is generally reflected in the processes and terms of the emerging GP-led continuation fund market in Australia.
The guidance offers assistance in designing fair processes and terms which allow sponsors and investors to unlock the benefits of continuation funds in a way that benefits all stakeholders. Adherence to these standards will mean GP-led secondaries can be governed by the bargain and processes struck between sophisticated wholesale and institutional investors, LPACs and sponsors, without being subjected to increased regulatory scrutiny and oversight.
About Allens: Allens has a leading secondaries practice in the Australian market, acting on the two largest GP-led secondaries transactions in the past two years, as well as advising on in excess of $3 billion of secondary sales transactions across 30+ fund LP interests spanning buyout, venture capital and growth, credit and infrastructure since 2021.