For managers (i.e. the Sponsor) of closed-ended private equity funds (including real estate or infrastructure funds), continuation vehicles offer the Sponsor an alternative to the traditional exit routes for investments.
In a CV structure the Sponsor will transfer an asset (the "CV Investment") from its existing fund to a newly established continuation vehicle ("CV"), also managed by the Sponsor.
The investors (being the limited partners (the "LPs")) in the existing fund have the option to either re-invest their commitment into the CV, or to cash out (a partial sale option may also be offered) on the sale by the existing fund of the CV Investment to the CV. New LPs (often secondary funds) will also usually come into the CV to provide additional capital. Any existing LPs that have re-invested into the CV might also have the opportunity to increase their commitments to the CV.
1. Rise in Continuation Vehicles
The number of CVs (and particularly single asset CVs) has increased significantly over the last 3 to 4 years as private equity funds have used CVs as an alternative to realise investments.
The CVs in the current market are typically either established for the "trophy assets" of the existing fund where the Sponsor sees further upside in holding the asset(s) for longer or where the current lifespan of the existing fund won't achieve the optimal outcome on exit of the relevant asset(s).
2. Key considerations - general
Pricing conflict and asset valuations: As the Sponsor is on both sides of the transaction in a CV structure – as buyer and seller – the Sponsor will need to manage that conflict of interest carefully, particularly the inherent pricing conflict between those LPs that want to cash out, and those that want to re-invest into the CV.
The Sponsor will also need to manage any potential conflict between its own interests and those of the LPs. For that reason, and to ensure sufficient interest among new and existing LPs for the CV, it is critical that the Sponsor sets the right economic terms to ensure alignment of interests.
Economics / key terms: The Sponsor will need to demonstrate alignment and retain exposure to the CV Investment – this is usually achieved by rolling any crystallised carried interest the Sponsor has earned in the existing fund, into the CV. Typically 100% of crystallised carry will be rolled into the CV.
The Sponsor may also be required to put in new money. The size of the Sponsor's commitment to the CV will be a particular focus for LPs (and asset level lenders who are lending to the CV Investment) where the existing fund is not yet in carry and the Sponsor does not therefore have carried interest to roll in to the CV.
The current average term of single asset continuation vehicles is 4 – 5 years with two 1-year extension periods.
3. Key considerations - asset level debt
The Sponsor and any asset level lender to the CV Investment will need to consider the following in connection with the transfer of that CV Investment from the existing fund to the CV:
Change of control implications: aren't as relevant given the Sponsor manages the CV. Asset level lenders will be more concerned with ensuring the Sponsor remains invested in the CV and the CV Investment and that the Sponsor retains "control" of the CV (either through the GP or LPA controls).
Skin in the game: Asset level lenders will want to ensure the Sponsor remains invested in the CV and the relevant CV Investment and so will be focused on rolled carried interest and the level of Sponsor re-investment (particularly where the Sponsor does not yet have carried interest to roll in to the CV).
Cash leakage: given the "sale" of the CV Investment to the CV, lenders will be focused on identifying (and minimising) cash leakage - particularly understanding whether any group cash is used to fund exit fees, transaction costs and any leaver pay-outs or management bonuses.
Equity arrangements: existing shareholder agreements will need to be terminated and new equity documents will need to be entered into. Where relevant, lenders may need comfort that key Sponsor controls are retained over the CV Investment. Sponsors will also need to ensure they have permissions to pay any increased monitoring (or similar) fees and/or holding company expenses on an ongoing basis.
Tax implications: all parties will need to take comfort that the tax (and VAT) implications of the CV transaction are thoroughly considered (generally through a detailed steps paper/ structure memorandum shared with lenders).
Group Structuring/Reporting: to avoid any wholesale changes to the "banking group", Sponsors should take care to make as few changes to the banking group structure as possible and ensure consolidated reporting remains at the level existing prior to the CV transaction.
Futureproofing: given extended lifespan of the CV, parties may need to consider whether the fund requires extension of debt facilities, refinancing or ensuring the debt is portable on any future sale. Any post-completion reorganisation steps will also need to be discussed between parties and ideally pre-baked into lender consents provided at the time of the CV transaction.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
