Although the private equity industry is confronted with a complex environment marked by challenges in exiting positions, secondaries--especially continuation funds--can help ensure capital flows and system efficiency. But it’s key to properly manage conflicts of interest when transferring assets from a primary fund to a continuation fund, which are both in-house vehicles.
, partner at the law firm Arendt & Medernach, explained that a significant challenge in these transactions is the management of conflicts of interest, particularly in general partner-led deals where the same manager effectively acts as both the “seller” and “buyer.” “You must manage them in such a way that you do not end up in court,” he told Paperjam. Lawyers play a crucial role in identifying these conflicts and providing guidance on how to mitigate them legally by seeking independent pricing, obtaining third-party opinions and getting investors’ consent.
Getting the best price here should not be the worst price on the other side
Joaquin Ruiz Tarré, head of secondaries at the European Investment Fund, noted that the is an invaluable source of insight for GPs, limited partners (LPs) and advisors on the best practices to protect--first and foremost--the interests of investors, avoid the mismanagement of the company to be transferred and, importantly, give guidance to GPs to adequately manage their conflicts of interest. “When discussing with GPs, the EIF expects them to follow the recommendations by the book… which are largely based on common sense,” he explained.
Continuation funds: a motivated GP
In a continuation fund, when a transaction crystallises carried interest, the GP’s commitment can be significantly higher, explained Ruiz Tarré. This is because current market standards require the GP to reinvest most--if not all--the entire carried interest (net of taxes), which is also in line with the recommendations from the International Limited Partners Association. Whereas GP commitments in primary funds is around 1% to 2%, the GP commitment percentages in continuation funds can reach levels above 4%. “We have seen even over 10%,” he said. “The alignment of interest with the GP is not guaranteed, but it can be pretty high. As a secondaries investor, we want the GP to be highly motivated.”
Investor consent: transparency and equal treatment
For Dusemon, auctions serve as price-making mechanisms within a transaction. Auctions can be open or highly selective, involving only a few chosen, trustworthy lead bidders, depending on the strategy. They can be very private or public. While not always the primary method for conflict reduction, auctions establish a pricing benchmark, followed by negotiations and the securing of additional investors to close the deal. “Getting the best price here should not be the worst price on the other side,” he stressed.
Dusemon commented that securing investor consent through a transparent and trusted process is key. The process must guarantee “equal treatment” and “fair treatment” of all investors. The most complex aspect is often reconciling the interests of investors with those of the managers to foster trust and ensure the continuous flow of capital. This frequently necessitates multiple negotiation rounds, especially with diverse investor bases. He highlighted that the role of legal advisors in those deals is to help GPs complying with fiduciary obligations to the investor in its old fund and to act in the best interest of the new ones.
On the side of the European Investment Fund, before investing in continuation funds, the EIF looks for:
- Competitive process: ensuring multiple secondaries buyers bidding on the assets
- Independent valuation: obtaining a “fair opinion of valuation” from one of the Big Four firms.
- GP commitment: GPs are expected to reinvest all their carried interest (proceeds) from the sale into continuation funds, and often significantly increase their commitment, aligning their interests more strongly than in classic funds.
Ruiz Tarré commented that large investors (limited partners) in the continuation fund may take the lead in negotiating the purchase agreement to ensure an equitable outcome. “There will always be a conflict of interest on those deals,” said Ruiz Tarré. Guidelines provided by the ILPA aim to ensure a "well-managed" conflict of interest, rather than eliminating it entirely. To ensure its efficient management, he noted that the original fund’s advisory board must approve the continuation fund transaction, acting as a critical check on conflicts.
Deal negotiations may spin out of control
Dusemon explained that these transactions are inherently complex and time-consuming, sometimes requiring six months to a year to finalise. Some complex considerations may have to be taken into account, such as determining the necessary amount of capital in the continuation fund to roll over, whether new or replacement capital is needed, and the role of debt. In the meantime, market conditions may shift, or the invocation of "material adverse change clauses” can disrupt or even terminate deals, leading to renegotiations or parties withdrawing.
“We play an important role, but we are not the decision-makers,” stated Dusemon. “We are only the enablers from a legal or from a management point of view in certain circumstances.”