What are continuation funds and how do they work?

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Continuation funds are venture capital, private equity, real estate, or other types of investment funds that extend the investment period for certain assets in an already created fund that is ending its period of existence. Specifically, this term refers to cases where a general partner (GP) wants to maintain management of the portfolio acquired by one of the GP’s funds. The main motivation for a GP to raise a continuation fund is to take advantage of the portfolio’s further growth potential beyond the original fund’s duration. In other words, when the GP believes greater returns can be achieved over a longer period than the allowed by the current fund, this option may be considered.

This approach allows the GP to continue managing the portfolio, which would otherwise have to be sold to third parties due to the investment policy of the fund. Note that, in most cases, there is an obligation to liquidate the fund after a period of 9 to 12 years. Moreover, using a continuation fund allows existing fund investors (LPs) to decide whether to exit their position or reinvest in the continuation fund alongside the GP. In most cases involving continuation funds, some LPs choose to take their returns, while others reinvest part or all of their share, or even invest more in the new continuation fund.

Another key aspect of continuation funds is that the GP's deeper understanding of the portfolio allows them to decide which assets (companies) can be better monetized by selling through the original fund or transferring them to the continuation fund for a more advantageous sale later on. Additionally, continuation funds benefit from being immediately operational, as they already have an invested portfolio. This is significant because some funds experience lengthy periods in trying to find suitable investments or, even after identifying them, fail to acquire the targeted assets. This may happen if agreements with sellers or companies aren’t reached, or competitors (other GPs or industrial firms) win the bidding for these assets, leaving the fund without viable investment opportunities.

The use of continuation funds introduces additional complexity compared to an ordinary fund, as it not only requires typical fund setup tasks but also the management of conflicts of interest and the transfer of assets from the original fund to the continuation fund. A particularly complex part of this process is determining which assets will be transferred and at what price. For this reason, third party expert reports are crucial for asset valuation, ensuring that transfers between funds are executed at market value. It is essential that the GP guarantees all assets from the original fund are transferred at fair market value, especially those moved to the continuation fund.

While external appraisers are commonly used in such cases both in Spain and in many other countries, it’s important to note that this does not guarantee regulatory compliance (at least in Spain). In a Q&A on the topic from July 17, 2023, Spain's CNMV (National Securities Market Commission) highlighted the risk of over or underpricing in these reports: “In determining the transaction price, supervisory experience indicates that the prices estimated by independent experts are not always representative of the market value of a transaction. Therefore, while useful for valuation or as a benchmark for prices offered by third parties, they should be treated with caution for transactional purposes.”

As the assets are transferred from the original GP-managed fund to another fund managed by the same GP, there is always a conflict of interest that needs to be addressed.

The most common practice to manage this conflict of interest is obtaining approval from investors or the Supervisory Committee to authorize the asset transfer to the continuation fund, as well as an independent expert valuation of the assets (third party’s valuation).

Another way to mitigate the conflict of interest is through transparency and disclosure about the transaction, particularly during the setup and marketing of the continuation fund. Since the continuation fund is being created to acquire assets from another fund managed by the same GP, the commercial documents, especially the fund’s prospectus (and the private placement memorandum), must include information about the portfolio the new fund intends to acquire from the previous fund. Typically, the continuation fund doesn’t limit its investment solely to the previous fund’s assets; rather, this portfolio usually represents only part of the new fund's investments. As the initial portfolio is transferred to continue its growth strategy, the investment policy of these continuation funds generally includes the possibility of making additional investments in the initial portfolio. Thus, the founding documents of the continuation fund will detail part of the assets to be acquired (those transferred between the GP's funds), but the remainder of the investment will include additional investments in the initial portfolio as well as new projects that the GP will need to identify and invest in during the new fund’s investment period.

Another strategy for continuation funds is to invest in only one or a few companies (between one and five) from the original fund, which the GP wants to hold due to their future growth potential. However, this strategy involves significant concentration risk, especially when a GP wants to maintain a single company for its expected future value. Additionally, many investment vehicles have diversification thresholds that limit the use of these kind of concentrated strategies.

There are other specific features of continuation funds that must be considered, such as the fee structure for GPs. In these funds, the GP’s reduced workload usually results in lower management fees and success fees (carried interest). However, this depends on various factors, particularly the weight of the initial portfolio and the operational burden for the GP.

Finally, two other delicate issues should be noted, in addition to the aforementioned conflict of interest. First, the content of the representations and warranties (R&W) to be granted by the original fund to the continuation fund. Second, the allocation of transaction costs, which can be significant (e.g., the costs of independent experts for portfolio valuation, which could be borne by the seller, the buyer, or both).

In conclusion, to avoid confusion, it’s important to note that secondary funds are not the same as continuation funds. Secondary funds aim to acquire assets or portfolios from other funds managed by different GPs, whereas continuation funds are set up by the same GP to continue investing in existing assets. They should also not be confused with successor funds, which are newly established funds by the same GP with the same or similar investment policies as the previous fund, intended to continue investing with the same strategy as the earlier fund now in its divestment phase.