Continuation Funds: Valuation and Fairness Opinion Considerations

By: Justin Johnson | Chad Rucker

Estimated reading time: 3 minutes

The article in brief:

  • Always a good idea, independent fairness opinions are likely to soon be required for certain interfund transfers.
  • While the proposed rules are still subject to revision, it seems clear the SEC will require fairness opinions for continuation funds, which have seen explosive growth in recent years.
  • Sponsors contemplating a continuation fund should consider how they will comply with the new rules when finalized.

It has always been best practice for general partners to seek a third-party fairness opinion when transferring assets between a legacy fund that may be winding down and a continuation fund set up to acquire one or more positions. Such transactions are rife with potential conflicts of interest between all the different constituents—GPs that have a fiduciary duty to both investors in the old fund and the new continuation fund; incumbent limited partners that want to cash out at a fair price; incumbent LPs that want to transfer their interest in the asset to the new fund and, finally, new LPs buying in to the continuation fund.

With so many interested parties, an independent valuation and fairness opinion makes good business sense to the extent it makes the constituents comfortable that the transaction is fair to them from a financial point of view. It’s also prudent from a legal standpoint.

Another important party, the SEC, is weighing in and what was always a best practice appears likely to become a regulatory imperative.

The SEC recently proposed new rules under the ’40 Act that would require GPs to obtain—and share with interested parties—a fairness opinion from an independent opinion provider:

“…where an adviser offers fund investors the option to sell their interests in the private fund, or to exchange them for new interests in another vehicle advised by the adviser. This would provide an important check against an adviser’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of private fund investors.”

In its proposal, the agency avers that there is a legitimate role for adviser-led secondary transactions because they can provide one group of investors with liquidity while buying time and sometimes providing additional capital to help investments to mature, thereby maximizing value for investors that wish to remain in the fund.

However, the SEC also cites the potential for conflicts of interest:

“For example, because the adviser may have the opportunity to earn economic and other benefits conditioned upon the closing of the secondary transaction, such as additional management fees or carried interest.”

The proposal calls for advisors to obtain a fairness opinion that assures investors that the price being offered for the asset(s) is based “on underlying valuation that falls within a range of reasonableness.”

The proposal is part of a larger set of proposed rule changes that the agency issued in early February 2022. While the details may change and additional implementation guidance will likely be forthcoming, the vote was 3-1, suggesting some version of the requirement is likely to be adopted.

Whatever the final rules look like, they will impact a large and rapidly growing market. According to Credit Suisse’s 2022 Secondary Market Review report, at least 11 continuation funds were launched or closed in 2022 with a median transaction size of $609 million. In 2021, GPs launched or closed GP-led transactions topped $68 billion globally, a 94% increase over 2020.

Much of 2021’s increase had been driven by the pandemic and the resultant challenges in executing initial public offerings, but the interest in continuation vehicles has not yet faded. Sponsors have become increasingly comfortable with continuation funds as yet another tool in their quiver, along with IPOs and sales to strategic or financial buyers. They can provide those LPs seeking liquidity with an exit while allowing the GP and like-minded investors to maintain exposure to a company that may be taking longer to unlock the value originally identified by the sponsor. They also create a mechanism for raising additional capital that may be required to optimize the legacy investment.

The process of providing a continuation fund fairness opinion is already a complex process and may become more so when the SEC rules are finalized. VRC is one of the leading providers of fairness opinions for continuation funds and fund-to-fund restructuring transactions, having provided fairness opinions for many $1 billion + transactions. VRC also provides monthly, quarterly, and annual valuation services of illiquid, hard-to-value securities for many leading pension and private investment funds.