What Are Continuation Funds in Private Equity?

Continuation funds are a financial mechanism used in private equity to manage specific investments. They provide flexibility for fund managers and investors regarding assets that have reached a certain lifecycle stage but still hold significant value potential. This approach allows for continued management and value creation for select portfolio companies.

Understanding Continuation Funds

A continuation fund is a specialized private equity vehicle established by a General Partner (GP) to acquire assets from an existing fund nearing its operational term end. This structure functions as a secondary transaction, enabling the GP to maintain ownership and management of specific assets. This differs from the traditional private equity model, where assets are typically sold to an unrelated third party.

Continuation funds allow the GP to extend the holding period for promising investments beyond the original fund’s lifespan. Existing investors, Limited Partners (LPs), can either exit their investment for cash or reinvest their stake into the new continuation fund. This provides a liquidity option for LPs while allowing the GP to continue managing high-performing assets that may require additional time to mature.

The Private Equity Fund Life Cycle and Continuation Funds

The life cycle of a traditional private equity fund typically spans approximately ten years. This cycle generally unfolds in distinct phases: fundraising, investment, and harvest or liquidation. In the initial fundraising stage, the private equity firm secures capital commitments from institutional investors to form the investment pool.

Following fundraising, the fund enters its investment period, during which the GP identifies and acquires portfolio companies. The private equity firm actively works with these companies to implement operational improvements and growth strategies, aiming to enhance their value. The goal is to prepare these companies for a profitable exit.

As the fund approaches its end, it enters the harvest or liquidation phase, where the private equity firm seeks to exit its investments and return capital to its LPs. Exits traditionally occur through sales to strategic buyers, initial public offerings (IPOs), or sales to other private equity firms. However, some assets may still have significant growth potential that cannot be fully realized within the original fund’s remaining term.

A continuation fund allows the private equity firm to transfer these specific, high-potential assets from the original fund into a new vehicle, effectively extending the investment horizon for those particular holdings. This mechanism addresses situations where market conditions might not be optimal for an immediate sale, or where the GP believes additional time and capital can unlock substantial further value. This flexibility ensures that promising investments are not prematurely liquidated due to fund term limits.

The Mechanics of a Continuation Fund Transaction

Establishing a continuation fund involves the General Partner (GP) of the original fund, existing Limited Partners (LPs), and new investors. The transaction begins with the GP identifying one or more portfolio companies from the existing fund that they believe possess significant unrealized value and warrant a longer holding period.

Once the target assets are identified, a new legal entity, typically a Special Purpose Vehicle (SPV) structured as a new fund, is created to acquire these assets. An independent third-party firm conducts a valuation of the assets to be transferred. This valuation ensures a fair market price for the assets, mitigating potential conflicts of interest between the selling fund and the buying continuation fund, both managed by the same GP. This independent assessment is crucial for transparency and to establish a justifiable price for the transaction.

Existing LPs in the original fund are then presented with a tender offer, providing them with clear options regarding their stake in the transferred assets. They generally have three choices: they can elect to “cash out” by selling their pro-rata share of the assets at the independently determined valuation, thereby receiving liquidity. Alternatively, they can choose to “roll over” their investment into the new continuation fund, maintaining their exposure to the assets under the new fund’s terms. A third option often available allows LPs to sell a portion of their stake while rolling over the remainder, providing a hybrid approach to liquidity and continued investment.

New investors, often large institutional secondary buyers, provide the capital necessary to fund the cash-out option for existing LPs and may also contribute additional capital for future growth initiatives of the transferred assets. The assets are then formally transferred from the original fund to the newly created continuation fund entity. The GP continues to manage these assets within the new fund, often under a refreshed set of economic terms, including new management fees and carried interest structures. This reset aims to incentivize the GP to generate further returns from the assets, with carried interest typically calculated from the new asset valuation, aligning the GP’s interests with those of both rolling and new investors.

Defining Characteristics of Continuation Funds

Continuation funds possess several distinguishing features. A primary characteristic is their GP-led nature, meaning the transaction is initiated and orchestrated by the General Partner of the original fund. This contrasts with LP-led secondary transactions where an investor sells their interest in a fund to another party. The GP-led structure enables the manager to proactively manage their portfolio beyond typical fund constraints.

These funds typically focus on a concentrated portfolio, often a single asset or a small group of high-performing assets, rather than a diversified portfolio of numerous companies. This allows for a highly focused strategy aimed at maximizing the value of specific investments that the GP believes still have significant upside. The duration of continuation funds is generally shorter than traditional private equity funds, commonly structured with an expected investment period of three to five years, reflecting the more mature nature of the assets.

A new Special Purpose Vehicle (SPV) is created to house the acquired assets. This new legal entity provides a clean structure for the continued ownership and management of the assets and facilitates the entry of new investors. The tender offer process for existing LPs is a fundamental element, providing them with a formal choice to liquidate their position or reinvest. This mechanism ensures existing investors have an opportunity to gain liquidity while allowing those who believe in the continued potential of the assets to remain invested.

The economic terms of continuation funds can also differ from primary funds. Management fees, for instance, might be set at a lower rate, often around 1% of invested capital, compared to the typical 1.5% to 2% for new blind-pool funds. Carried interest, which is the GP’s share of profits, is reset based on the new valuation of the assets, providing a fresh incentive for value creation. Furthermore, it is common practice for the GP to roll over a significant portion, often 100%, of their crystallized carried interest from the original fund into the new vehicle, demonstrating strong alignment with investors.