The Risks of Continuation Funds: What Limited Partners Should Consider
Continuation funds have gained traction as an increasingly common tool for private equity firms to extend the life of existing investments. By transferring portfolio assets from an existing fund to a new vehicle—often with the participation of new investors—general partners (GPs) can secure additional time and capital to maximize value. However, while continuation funds may offer benefits, they also come with notable risks for limited partners (LPs). Below, we highlight the primary risks LPs should be aware of.
1. Conflicts of Interest
Continuation funds often create inherent conflicts of interest between GPs and LPs. GPs typically drive the valuation of assets being transferred to the continuation fund, creating a potential for overvaluation, particularly if the GP's reputation or compensation is tied to the perceived success of the original fund. GPs must also balance their fiduciary duties to LPs in both the original and continuation funds, which can lead to decisions that prioritize one group over the other.
2. Increased Fees and Expenses
Continuation funds can result in higher costs for LPs, which may erode returns. The transfer of assets often incurs legal, advisory, and administrative fees. LPs who roll over into the continuation fund may be subject to a new set of management fees, even if they have already paid substantial fees in the original fund. A continuation fund typically restructures the carried interest terms, potentially requiring LPs to pay additional carried interest in the new vehicle. Importantly, LPs might still incur carry obligations even if the aggregate performance of the investment resulted in a loss or failed to surpass the preferred return threshold that would traditionally trigger the GP's entitlement to carried interest.
3. Limited Transparency and Input
LPs often have limited influence over the terms and structure of a continuation fund. LPs may not have full visibility into the GP's decision-making process or the rationale behind the continuation fund, and LPs in the original fund are often given limited choices—either roll over into the continuation fund or sell their interest, potentially at a discount.
4. Concentration Risk
Continuation funds can increase concentration risk for LPs, particularly those who roll over their investments. Instead of diversifying into new opportunities, LPs remain exposed to the same portfolio assets, which may require more time to achieve targeted returns (increasing the risk of underperformance) and may face greater market fluctuations, regulatory changes, or industry-specific downturns over prolonged holding periods.
5. Potential Misalignment of Interests
GPs often use continuation funds as a way to realize liquidity while continuing to manage the assets, which can reduce their motivation to optimize long-term performance, especially if the GP has received a significant carried interest distribution from the original fund. New investors in the continuation fund may also negotiate more favorable terms, potentially disadvantaging rollover LPs from the original fund.
What LPs Should Do
To mitigate these risks, LPs should demand independent valuations from a neutral valuation agent to ensure fair pricing; scrutinize fee structures by evaluating the cumulative fees and carry; engage in negotiations to advocate for terms that align GP and LP interests and provide equal treatment to all investors; and assess the rationale for creating the continuation fund and evaluate whether it aligns with the LP's investment goals. By staying vigilant and actively participating in the process, LPs can better protect their interests and ensure alignment with their broader investment objectives.
This article is provided for general informational purposes only and does not constitute legal or tax advice. You should always consult with a qualified attorney or tax adviser regarding your specific circumstances.