Over the past few years, continuation fund transactions have gained acceptance as an exit strategy from portfolio company investments for private equity funds. Unlike a traditional sponsor exit from a portfolio company investment via an IPO or a sale to a third party, in a continuation fund transaction, the same sponsor typically continues to control the portfolio company. As a result, continuation fund transactions can raise unique considerations regarding management equity investments and awards, which we discuss below.

Overview

Continuation fund transactions can be appealing for a number of reasons: to provide liquidity to limited partners, to allow the sponsor to hold an investment beyond the existing fund’s expected duration, or because market conditions for a traditional exit are unfavorable. In the transaction, the existing fund will sell the portfolio company investment to a new vehicle controlled by the new continuation fund, and some or all of the limited partners who hold interests in the existing fund may be offered the option either to roll their interests in this portfolio company investment into the continuation fund or to cash out of the investment. In addition, cash may be raised from new investors in the new vehicle to fund this cash out of investors from the existing fund. The transaction may or may not crystallize sponsor carried interest. After the closing of the transaction, the original sponsor continues to control the portfolio company through the new continuation fund and typically with new and continuing limited partners as co-investors.

Effect on Management Equity

As part of the preparations for a continuation fund transaction, a sponsor and its counsel will need to review the contractual provisions that apply to management’s equity in the portfolio company, which may include both (1) “incentive equity,” such as options or profits interests; and (2) “invested equity” that management rolled over or purchased when the sponsor originally acquired the portfolio company. Different considerations apply to each.

1.Considerations Related to Management’s Incentive Equity

A threshold question for a sponsor preparing for a continuation fund transaction is whether, under the existing plan documents, the transaction will constitute a vesting and/or liquidity event that accelerates the vesting of some or all of management’s incentive equity. If so, the plan terms will typically need to be followed unless they can be amended or management consents to a change. Often, the central factor in this analysis of the documentation will be the definition of key terms such as “change in control,” “sale of the company” or “liquidity event.” For example, if those definitions exempt affiliate transactions—as is frequently the case—and if the new fund and old fund are both controlled by the same sponsor, a continuation fund transaction often will not constitute a triggering event.

If the continuation fund transaction does not constitute a triggering event under the applicable plan documents, the sponsor will have more flexibility as to how to treat outstanding incentive equity in the transaction. However, there is little precedent or established market practice to guide that treatment. Sponsors and their co-investors may find it helpful to consider some or all of the following considerations in deciding whether it is fair and equitable for management to participate in the transaction as if it were a sponsor exit:

• Why is the continuation fund transaction occurring? Do the reasons for the transaction align better with liquidity for management (e.g., a long-held portfolio company) or a full management roll?
• Does the incentive equity still provide the right motivation and incentive? To what extent is the incentive equity vested? Are there any arguments that management would be receiving a windfall by being permitted to cash out, or that management is being treated unfairly in the transaction?
• What benefits is the sponsor receiving from the transaction, and how do those benefits compare with those received by management? Are there cogent reasons why the two should be treated differently?
• What are the management team’s expectations and how reasonable are those expectations? How much leverage does the team have?
• How much value has the management team delivered through the date of the continuation fund transaction (i.e., how much embedded value is there in the incentive equity)? How compelling is the argument that significant value still remains to be realized?

Once these considerations are evaluated, a path forward can be identified. That path can take several forms. The sponsor could offer management the option to cash out, remain invested or take a limited amount of liquidity off the table. The incentive equity could be recapitalized into invested equity along the lines of a rollover in a third-party sale. Different tranches or types of incentive equity could be treated in different ways to maximize retention and incentive considerations (e.g., cashout of vested service-vesting equity and retention of MOIC-based or other unvested performance-vesting equity). The sponsor might require management to agree to re-vest some of their incentive equity in exchange for liquidity of other equity. In some cases, a continuation fund transaction might be treated as a full synthetic exit—in the same manner as an exit to a third party, with a negotiated elective rollover in which incentive equity is converted into fully vested invested equity and a new incentive equity program is rolled out.

2. Considerations Related to Management’s Invested Equity.

As with management’s incentive equity, the baseline question regarding invested equity is whether the applicable subscription agreement and limited liability company, partnership or stockholders’ agreement include provisions, such as tag-along rights, that may be triggered depending on the structure of the transaction. If not, sponsors would perform an analysis similar to that outlined above for incentive equity. If non-management limited partners are being given the option of cashing out or rolling their investment in a continuation fund transaction, management may have justifiably strong feelings about their ability to monetize a proportionate share of their invested equity. Sponsors may welcome the opportunity to provide management with liquidity, or may also negotiate for management to continue to keep as much “skin in the game” as possible. Typically, the resolution of the treatment of invested equity would be managed holistically with the treatment of incentive equity.

Looking ahead

Given the increasing viability and prevalence of continuation fund transactions, it would be a natural development for the market to begin to address the issues raised by these transactions at the outset, when equity plans are first established at a newly acquired portfolio company. We have seen management counsel begin to raise continuation fund treatment in the initial management equity negotiations, although the range of variables and considerations makes it difficult to pre-bake the right outcome up front. Depending on the dynamics of negotiations with the management team, if the portfolio company is able to exclude a continuation fund transaction from an automatic triggering event, it will maximize flexibility at the time of the transaction. We expect that over time, a clearer sense of market practice regarding these issues will emerge.

Private Equity Report Spring 2024, Vol 24, No 1