The boom in continuation funds, which now make up as much as 20 percent of private equity fund exits, has drawn scrutiny from the Securities and Exchange Commission, which is examining potential conflicts of interest, valuations, and disclosure issues.
The SEC, whose rule governing private fund advisors was struck down by the Fifth Circuit Court of Appeals in 2024, is nonetheless looking at some of the issues that rule was meant to address, said Paul Foley, an attorney with Baker Donelson. The rule would have required continuation fund sponsors to obtain a fairness or valuation opinion from an independent provider and disclose any material business relationships with that provider.
In June, Reuters reported that the SEC was looking closely at continuation funds. Foley said his firm is aware of an SEC “sweep” in the private equity industry, with a number of managers “actively engaged with SEC with respect to conflicts of interest, asset valuations, and whether disclosures are adequate and consistent.”
The scrutiny reflects the inherent structural conflict of a continuation fund: The sponsor generally controls the process on both sides of the transaction. Typically, when a fund is nearing the end of its life, but with some assets not sold, the sponsor may take one or two promising companies and put them in a new fund to give them more time to hold and ultimately sell them. Existing investors are generally offered a choice between cashing out and rolling their interests into the new fund, while new investors provide capital for the transaction.
Continuation funds have proliferated in recent years largely because “the exit market in private equity, especially for the LBO funds, is kind of dead,” Foley said. He added that some 30,000 unsold companies remain in private equity funds, which means that the growth of continuation funds will continue. “That’s a lot of businesses, and trying to figure out what to do with those assets is probably going to be the challenge of the coming years.”
The phenomenon is giving rule-makers pause. “The regulator is going to approach this with some skepticism,” he explained, because “you’re telling people it’s a great investment, but there seems to be no market for it.”
Valuations are another potential source of conflict. Sponsors are not required to obtain an independent valuation, he said. Even if the manager chooses an independent firm to make the valuation, it may choose one that it believes will offer the higher valuation, Foley said. The SEC is also examining whether disclosures to current and prospective investors are adequate.
The SEC is asking, “Are you telling the continuation vehicle investors the same things that you’re telling your existing investors? Is this valuation really a legitimate valuation? Do you have other conflicts of interest that you haven’t disclosed with respect to this sale?” Foley said. “They’re looking at getting the proper consents and then they’re also looking at all the material conflicts and have they been adequately disclosed.”
The reason sponsors want to move the asset into a new fund is an economic one for them: They are more likely to get an incentive fee in a fund holding just one promising company instead of having that company mixed with losing assets, which means any gain it makes might not result in an incentive fee, Foley explained. (He also said the claim that only the “best” assets end up in continuation funds isn’t always true.)
Although the SEC requirement for a fairness opinion was struck down, Foley said more private equity sponsors are going ahead and getting one anyway. It is “helpful, in providing some additional cover to the sponsor.”
One private equity fund settled with the SEC over allegations that it breached fiduciary duties in a continuation fund.
But that case was brought when Gary Gensler headed the SEC, which had also proposed the previously mentioned new rule. However, the SEC has continued to look closely at the issue under current chair Paul Atkins. In May, David Woodcock, the director of enforcement, mentioned such concerns in an address at the MFA legal and compliance conference.
In addition to regulators, a number of lawsuits have raised questions about the consent mechanism, according to Foley. In one Delaware Court of Chancery case, the Abu Dhabi Investment Council alleged that a sponsor pursued LPAC (limited partner advisory committee) approval on a compressed timeline, restricted communication among LPAC members, provided disclosures inconsistent with information shared with prospective buyers, and set a cash-out price at an unjustified discount to internal valuations. (The court approved a stipulation halting the transaction pending independent review but ultimately cleared the deal.)
In many funds, a limited partner advisory committee can consent to the transaction for all investors — which makes Baker Donelson wary. “Sponsors and investors should resist merely following LPAC provisions granting blanket waivers for continuation fund conflicts at fund formation,” according to the law firm.
In a post on its website, the law firm said that “All investors, not just LPAC members, should receive the same material information at the same time. Selective disclosure or providing materially different information to prospective buyers than to existing limited partners undermines the election process and may expose sponsors to breach of fiduciary duty claims.” It added that “transaction prices should be clearly articulated relative to the most recent Net Asset Value (NAV), with any discount or premium transparently disclosed.”
Baker Donelson also suggested that sponsors provide a consolidated disclosure covering the rationale for pursuing a continuation fund rather than alternative exit paths, including details of the competitive bid process and basis for selecting the winning bidder, economic terms, any stapled commitments or ancillary relationships between the acquirer and sponsor, and the allocation of transaction-related expenses.
The Institutional Limited Partners Association guidance provides that there should be no crystallization of carried interest for rolling investors, and that sponsors should roll all accrued carry into the new vehicle to preserve alignment.
