Conflicts of Interest in Continuation Funds

This report is the second of a three-part series on ethics in private markets. The first report, Continuation Funds: Ethics in Private Markets, Part I, explains what continuation funds are and concisely summarizes the key ethical issues they raise. Continuation funds are also called continuation vehicles (CVs), and we use both terms interchangeably.

In efficient capital markets, prices are determined by arms-length transactions between buyers and sellers. But what happens when the buyer is the seller? That is the question posed by continuation funds, where the general partner sits on both sides of the same transaction. This dual role is not unprecedented — management buyouts offer another example — but it raises heightened conflict-of-interest and ethical questions.

The GP functions as the agent of the sellers (the LPs who cash out) and will become the agent of the buyers (incoming investors) once the CV is established. The GP owns an equity stake in the legacy fund and will take an equity stake — often a larger one — in the CV. The GP has strong financial incentives yet plays a key role in the process to determine the CV transaction price. That role includes leading a competitive bidding process, selecting a lead investor, and negotiating with the latter. Finally, the GP continues to serve as manager of the legacy fund and also will manage the continuation fund.

This report explores these major conflicts of interest and identifies actions that would be unethical if undertaken. The report also describes best practices that have evolved to manage the conflicts. Our purpose is neither to denigrate nor to defend CVs but, instead, to offer an even-handed and fair explanation of the conflicts and ethical issues. A primary goal is to raise the awareness of practitioners and help them navigate conflicts and act ethically. Another goal is to inform regulators, the media, and other interested persons.

The CV transaction price is the outcome that matters most for all the CV participants. It is the litmus test that determines the fairness of the CV transaction. But how do we judge the fairness of the transaction price?

Incoming investors in the CV face the risk of adverse selection. Are they paying too much to buy equity in overpriced assets? (If so, that might explain why the assets cannot be sold at a price acceptable to the GP in a traditional exit.) Selling LPs, in contrast, face the risk of inadequate consideration for their interests. Are they leaving money on the table by selling the assets for less than they are worth? These questions are particularly difficult to answer because price discovery in CV transactions is neither objective nor fully independent.

The contrast with public markets is instructive. Public markets offer price discovery that is continuous, observable, and objective. Private funds, in contrast, typically hold their portfolio of assets for years before disposing of them. In the meantime, the assets are illiquid. There is no trading to offer an objective and observable market price. The market price comes into view only in an eventual traditional exit, which transfers both ownership and control to a third-party buyer (or to the investors in an IPO).

Unlike a traditional exit, however, the CV allows the GP to retain control (and some equity) even after the transaction. Furthermore, the GP plays a central role in forming the CV and establishing the transaction price. To be sure, the process typically involves a sophisticated third-party lead investor who negotiates the price and other terms with the GP. In addition, the GP may obtain a fairness or valuation opinion from an independent provider. Nonetheless, the GP directs the process: It solicits bids, selects the winning bid, and negotiates with the winning bidder (i.e., the lead investor) to settle on a price and agree to the other terms of the CV. This arrangement makes the price discovery process significantly less than fully independent.

Nor is the process objective. In the absence of an observable and independently established market price, the most theoretically sound way to establish the intrinsic price of an asset is to forecast its future sale price and discount that back to present value. That approach, however, introduces subjectivity and reliance on models to estimate future value and risk. No matter how skilled and astute the GP is and no matter how scrupulous its due diligence is, its assumptions remain subjective and its predictions remain subject to error. Intrinsic value is based on the asset’s future prospects and eventual sale price. But those projections cannot be tested or verified at the time of the CV transaction; only time will tell.

As a result of these challenges, we cannot simply rely on the transaction price to judge the fairness of a CV transaction. Instead, we must also rely on the fairness of the process. Did the GP vigorously and effectively solicit bids? Did it seek to drive a hard but fair bargain in its negotiations with the lead investor, faithfully discharging its duties of care and loyalty?

Although the price discovery process can never be completely independent or objective, the GP can strive to attain those objectives as closely as possible. We judge the fairness of the CV by the extent to which the process succeeds in approximating those goals.

A simple analogy drawn from the philosophy of procedural justice may be helpful. Imagine that 10 individuals want to divide a cake equally. The outcome will be fair if the cake is indeed divided into 10 equal pieces and distributed to each of the individuals. We have a clear and measurable standard by which to judge the fairness of the outcome.

But suppose instead that we are engaged in a different activity whose outcome cannot be measured directly. We have no independent criterion or clear standard by which to judge the outcome. We can, however, design a clear and fair process to be followed. Then, we can judge the fairness of our actions by how well we follow the process, whatever the outcome. Stated another way, procedure substitutes for output as a means to judge the fairness of the activity. While not a perfect analogy, it bears relevance to the challenge of judging the fairness of a CV transaction.

To anchor the analysis that follows, it is useful to distinguish three related but conceptually distinct phenomena: structural conflicts of interest, procedural failures, and intentional misconduct.

Structural conflicts of interest arise from the economic incentives and institutional arrangements inherent in continuation funds. Conflicts of interest should be avoided whenever possible, but doing so is not possible here. They are unavoidable in continuation funds, because the GP sits on both sides of the same transaction. The existence of a conflict of interest, however, does not in itself make a financial professional or entity unethical. This report explores actions for ensuring ethical conduct that adequately addresses the conflicts.

Procedural failures concern how those conflicts are managed. Even where conflicts are unavoidable, they can be mitigated by a fair and well-functioning process. That process includes full and timely disclosure, adequate time for decision-making, a vigorous bidding process, and appropriate governance. Conversely, material failures in process can render a transaction unacceptable or unethical.

Intentional misconduct involves actions that exploit conflicts of interest for the benefit of the GP at the expense of the legacy fund and its investors. These include concealment of material information, manipulation of valuations, and selective or misleading disclosures. Such conduct is unambiguously unethical and, in many jurisdictions, unlawful.

These distinctions are particularly relevant in settings where a single actor influences both sides of a transaction, raising concerns about self-dealing and the potential transfer of value across investor groups. This framework underpins the analysis in this report.

Section I focuses on structural conflicts of interest in CVs. The GP has key financial incentives that can raise conflicts of interest with the LPs. Though media and practitioner attention has focused on potential misalignments between the GP and LPs, competing interests can also arise among LPs themselves, as we will discuss.

Section II examines the processes that can be used to manage conflicts of interest in forming a CV. The section emphasizes the real-world complexities of CVs, in which investors can have competing interests, differing perspectives, and disparate outcomes.

Section III examines actions that would be unambiguously unethical if undertaken by a GP. These actions often result in squeezing out legacy LPs and appropriating their profits.

Section IV describes best practices and procedures designed to enable the GP to manage conflicts of interest fairly and ethically. We base our judgments on several pillars, including industry best practices and the CFA Institute Code of Ethics and Standards of Professional Conduct and the CFA Institute Asset Manager Code™.

The Conclusion elaborates on four key elements — price, other economic terms, process, and disclosures — that collectively represent hallmarks of a fair process. Practitioners can use these elements as guardrails as they seek to engage in ethical conduct and to address inherent conflicts of interest in forming a CV.

Appendix 1 situates the report’s framework within relevant strands of economic, legal, and ethical scholarship. We present this framework in an appendix to preserve readability in the main body of the report for practitioners and other nonacademic readers.

Appendix 2 describes our research methodology.

Conflicts of interest should be avoided whenever possible, but they are unavoidable in continuation funds because the GP sits on both sides of the same transaction. The existence of a conflict of interest, however, does not in itself make a financial professional or entity unethical. How one addresses a conflict of interest — by adequately mitigating and disclosing it — can determine whether the action is ethical or unethical.

The CV transaction price is the litmus test that determines the financial outcome for all participants. A completely objective and independent process is impossible, however, because the GP plays a central role in forming the CV and sits on both sides of the transaction. Nonetheless, a competitive and vigorous bidding process should approximate objective and independent price discovery to the extent possible.

The importance of process: Absent a completely independent bidding process, we cannot judge the fairness of the CV solely on the basis of transaction price. Instead of judging fairness on the basis of outcome (i.e., transaction price), we must assess the fairness of the process in forming the CV.

Status quo option: Offering rolling LPs the status quo option ensures that the CV treats legacy investors fairly and ethically. LPs should not be forced to choose between selling their interests and accepting materially adverse terms. It would be a violation of the GP’s duty of loyalty to the LPs to require them to accept materially adverse terms.

Disclosures must be materially complete, accurate, and timely, enabling legacy LPs to make informed choices. Many unethical schemes rely on concealment, misrepresentations, manipulation of data, and selective disclosures.