Rolling forward: The rise of continuation vehicles in private equity

1. Introduction

Continuation vehicles are investment structures that involve a private equity fund manager facilitating the sale of one or more portfolio companies from existing fund vehicle(s) (existing fund) to a new vehicle managed by the fund manager (continuation vehicle). The continuation vehicle will typically involve new investors (as well as, potentially, some investors from the existing fund).

While continuation vehicles are well-established in Europe and the United States, the use of continuation vehicles in Australia is just starting to gain traction. We are likely to see a greater uptake in Australia as a bona fide exit option, mirroring the experience in overseas markets, particularly with the IPO window continuing to be subdued. As the prevalence of continuation vehicles in the Australian market increases, it is important for private equity fund managers and investors to consider the key structural, valuation and governance considerations for such investment structures, which we cover in this article.

2. Continuation vehicles – developing use

Continuation vehicles were originally viewed as a potential solution for 'problem' assets held by closed-end private equity funds. If an asset held by a fund vehicle was not suitable for sale as the fund was reaching the end of its term, or market conditions were sub-optimal, a continuation vehicle provided additional turn-around time or allowed assets to be sold when market conditions improved. More recently, continuation vehicles are actually being used by fund manager's for their best performing assets, to provide existing investors with an exit and the manager more time to grow and develop (and provide new investors with exposure to) high performing assets.

In Australia, this may be a partial response to the subdued IPO window in Australia since 2021.

The use of continuation vehicles presents several strategic benefits for stakeholders, such as:

• Extended period of value creation: Enables fund managers to manage assets beyond the conventional private equity lifecycle of three to seven years, allowing the fund managers to execute further growth strategies for high performing assets.
• Liquidity option: Offers an exit opportunity for existing investors who wish to realise their investment, while accommodating those who wish to reinvest in a new vehicle. (The vast majority of investors in the continuation vehicle will be new investors, rather than the existing investors reinvesting. Often the existing investors' mandates do not allow for investment in single or limited asset funds.)
• Reduced uncertainty for new investors: Provides access to stable and mature investments that may present a lower risk compared to assets that are newly acquired by private equity managers.

3. Structuring considerations

Continuation vehicles generally differ from primary investment vehicles in a number of respects, such as:

• Shorter investment duration: Continuation vehicles typically have a shorter investment duration (three to four years), which enable investors to maintain exposure to performing assets without committing to a more traditional investment lifecycle.
• Concentrated portfolio: Continuation vehicles often contain a single asset, allowing investors the opportunity to reconstruct their portfolios or opt for liquidity.
• Lower management fees: Continuation vehicles typically charge management fees at a lower rate than the primary vehicle.
• Carry structure: Carried interest in continuation vehicles is often tailored for stronger alignment. Fund managers frequently push for a higher carry percentage than in the primary vehicle, or a tiered carry structure where the carried interest percentages ratchet up as the continuation vehicle hits its return targets.

4. Valuation considerations and sale terms

A key focus for both investors in the existing fund and the investors in the continuation vehicle are the valuation of the assets and sale terms. Industry practice is for the sale price of the assets to be supported by:

• where feasible, a market-driven valuation process to ensure that pricing reflects true asset value (e.g. a bookbuild run for investors into the continuation vehicle); or
• alternatively, an independent valuation of the assets.

Interests are better aligned when the private equity fund manager and, potentially, the founders, roll over a substantial stake at the same price as the existing and new investors.

Market practice is not yet settled for continuation vehicle transactions. However, unlike traditional M&A transactions, warranties in continuation vehicle transactions tend to be limited to information and title warranties. Extensive business warranties are less common, except where warranty & indemnity insurance can be utilised.

5. Managing conflicts of interest

Given that in continuation vehicle transactions the same private equity manager is on both sides of the transaction, there are inherent conflicts of interest that need to managed. Best practices for mitigating conflicts of interest include:

• Adequate disclosures: All necessary information about the selected asset(s) should be disclosed (for the new investors to carry out their due diligence), as well as the rationale for the transaction, process for soliciting bids for new investors, and details of any bids (i.e. number, range and content of bids considered) for the assets.
• Due diligence procedures: Vendor due diligence is commonly undertaken.
• Transaction timing: Rolling and new investors should be provided with sufficient time to review the transaction (best practice in the US is to provide at least 10 business days).
• Competitive valuation process: As described above, the fund manager can conduct a competitive valuation process, which includes third-party price validation, to ensure that a fair and market price is obtained for the selected asset(s).

6. Market outlook

Continuation vehicles are expected to play an increasingly significant role for private equity managers in Australia, particularly as the market matures and managers are seeking opportunities for managing longer-term capital.