Decoding the Secondary Market: Continuation Funds

[By Sayali Dodal]

The author is a student of Maharashtra National Law University Aurangabad.

 

Introduction

Over the past few years, the Indian markets have witnessed a remarkable growth fuelled by ever evolving desire of General Partner (“GP”) and Limited Partners (“LP”) to take part in secondary transaction structures with an aim to deliver solutions to the challenge faced by investors which is lack of liquidity. These GP led Secondary Transaction such as Strip Sale or Continuation Funds are utilized when, in the opinion of the GP, the investments would not yield the expected returns at the originally expected due time of making exits for closed-end funds. In recent years, continuation funds which involves setting up a new fund to simply transfer unrealized investments out of an existing fund, have emerged as an innovative investing method. Continuation funds provide a solution by extending the investment life cycle of venture capital and private equity funds thereby providing liquidity to early investors while also supporting business growth.

Presently, at the end of tenure of a scheme of an Alternative Investment Funds (“AIF”), the manager can seek extension of the tenure of the scheme by two years upon approval of two third of the investors which is decided on the basis of their investment in the scheme. Furthermore, after acquiring approval of at least 75% of the investors by value of their investment, the managers also have the option to distribute the assets of the AIF in-specie. In case neither of the aforementioned investors’ consent is received, or if the two-year extension  of  the AIF  is  complete without  investor  approval  for  in-specie distribution of  residual  assets, the AIF is left with no other option than to liquidate the scheme within one year in accordance with AIF Regulations of 2012.

The Fund is expected to exit its investments during the harvesting period, and in any case, upon the completion of its tenure. However, sometimes it may be more conducive from a value generation perspective to have a longer holding period for some of these investments. This necessitates a fine balance of expectations, since not all LPs may be on board with extending the holding period and may seek liquidity by the end of the originally communicated tenure of the Fund. Over the past few years, the branding of GP led secondaries has improved particularly in the light of COVID-19, and GP-led secondaries are being used more frequently to continue investments in assets which can potentially provide higher returns in future commonly referred to as the “trophy assets”. One way to structure secondary transaction is by Continuation Funds.

Mechanism Of Continuation Funds

Continuation Funds are a form of restructuring, partaking transfer of assets by an existing fund to a new fund. These new funds often invest in existing portfolios of successful early-stage firms, allowing initial investors to earn partial returns while reinvesting in fresh prospects. LPs in the existing fund can quit their investments (“Dissenting Investors”) while still being exposed to potential future gains since continuation funds provide liquidity or roll into the new, longer life fund. The purchase of interests from cashing-out LPs is funded by subscription funds from new LPs or current LPs increasing their stakes. Additionally, these new funds are typically managed by the same GP thus mirroring the old fund.

Continuation Funds provides General Partners two options: first, they can retain those assets that have given satisfactory returns and may generate additional value in future, and second, they can let the weaker performing assets to stabilise by giving it more time. A continuation vehicle can also be used strategically to create additional funds to be used in expansion prospects by investing in newer buildings or equipment.

SEBI’s Take On Continuation Funds

Keeping in view the growing popularity of Continuation Funds, Securities and Exchange Board of India (“SEBI”) issued a Consultation Paper in February, 2023 with the proposal to allow AIFs and the managers to carry forward unliquidated investment of a scheme upon completion of its tenure to a new scheme of the same AIF. As per the Consultation Paper, this step came as a response to the sample data collected by SEBI which highlighted the expiration of 24 AIF schemes with a total valuation of Rs. 3,037 crores in FY 2023-24. Another 43 schemes with a valuation of Rs. 13,450 would also expire in the subsequent FY 2024-25. With closure of an existing fund, the introduction of Continuation funds would benefit the investors by providing them the required liquidity while also ensuring disclosure, recognising its asset value  and tracing fund performance.

Accordingly, AIFs/managers can transfer unliquidated assets to a new scheme at the end of its tenure with the consent of 75% of investors by value. One condition to be imposed on such AIFs/managers is to arrange bids for atleast 25% of the unliquidated investment in order to provide liquidity to the investors who do not wish to continue. When the bid is obtained from related parties of the AIF/manager/sponsor or existing investors, it has to be disclosed to the investor for transperancy and according to SEBI such bids can only be used to provide pro-rata exit to other remaining investors”. It is assumed therefore, that to provide liquidity to the dissenting investor who do not wish to transfer to the new scheme, bids obtained from related parties or existing investors can only be utilised. But this pose the question that wouldn’t bids from parties who do not fall in this purview be used to provide liquidity? Another interesting point is that this obligation to obtain bids for 25% of the unliquidated investment is not mandatory since the proposal itself provides an alternative.  In case such bids cannot be arranged, the closing valuation of the scheme will be based on the liquidation value as determined under IBBI Regulation, 2016 or other IBC norms. The ambiguity concerning whether Dissenting investors have to be paid or not poses another issue. In the scenario when 25%  bids are obtained for the unliquidated assets, it would be possible to pay the investors who wants an exit. But if no bids are received then simply, where would the AIF get money from to pay the investors? Because of the prerequisite to have consent of 75% of investors in the old scheme, it is implied that such consenting investors would become investors in the new scheme. They would presumably not pay any cash and would simply exchange their old units for units in the new scheme. If certain new investors join the new programme, the cash corpus could be utilised to compensate the exiting investors. Again, the question is whether such a sum would be sufficient to cover the operating costs of the new network?

Interestingly, SEBI regulations, currently, do not prohibit acquiring unliquidated investment of any AIF by another AIF even if the manager or sponsor remains the same. Proposal of purchase on investments of any AIF has to be stated in the new AIF’s PPM format. In addition to that disclosure of any conflict of interest has to be stated as well to maintain transparency. However, the new AIF will still have to comply with the minimum requirements under AIF regulations like minimum scheme corpus requirement of Rs. 20 crore, minimum investment requirement from each of its investors of Rs. 1 crore all of which has been relaxed in the Consultation Paper. With SEBI’s intervention, now investors and managers can continue the life of an investment fund in order to save the assets. This also open the avenue for numerous transactions in the market. However until the regulations are amended there would still be ambiguity cornering the transaction.

Issues Faced By Continuation Funds

Conflict of Interest

When the assets of the Legacy Fund are acquired by the Continuation Fund, the GP is the common party on both the sides. This poses a direct conflict of interest for both the Legacy Fund and the Continuation Fund LPs because there is an incentive to both buy reasonably while simultaneously selling beneficially. Further, it is important for LPs to examine whether the GP is striking the right balance between alignment of LP interests and its own economics.

The GP would typically make a presentation to the LPAC of the Legacy Fund, seeking a waiver of conflict in respect of a proposed Continuation Fund. The GP is foremost expected to be transparent, and be agreeable to disclosure of all necessary information required by the LPAC for processing its request. The key documents to be submitted are

the independent valuation report of the continuing assets,

the proposed economics for exiting LPs versus rolling-over LPs (this would include the valuation for transfer),

the legal and tax analysis of continuation related restructuring and projections from the GP’s perspective as part of the overall plan for the Continuation Fund.

The LPAC may, depending on the fact pattern, even ask the GP to seek an LP approval in addition to LPAC’s clearance of conflict.

Since the assets are privately held and sold, there is no accurate appraisal of the assets. In such a conflict-ridden environment, how can you accomplish a totally impartial valuation when one of the buyer or seller  ‘appoints’ the valuer?

To finalise the pricing, third-party GPs or LPs (or a combination as an expert panel) may be brought in. Existing Legacy Fund LPs in need of liquidity may coordinate and request a tender offer of the Legacy Fund’s assets. In this situation, the buyer’s value may not be done, but rather determined by market forces. The LPs may achieve higher valuation due to the critical mass involved as many LPs coordinate to sell their share in the market. The Manager may also consider using a book-building process derived from investors submitting prices and sizes of interests they are looking to acquire; and/or pegging the sale price to a minimum “floor” price determined by a third-party sale of an equivalent interest in the asset.

Conundrum of the LPs

LPs may also insist more on indemnities covering breach of representations and warranties on top of traditional indemnities depending on the assets being continued. LPs also carry out an independent price discovery and buyer assessment exercise in such cases while making a decision.

Time Required

As per Regulation 4(i) of the AIF Regulations, 2012, the Manager of the AIF has to specifically disclose the proposed tenure of the fund or scheme at the time of registration. Presently, an AIF has an option to extend its tenure for two years if two-thirds of the LPs by value approve such an extension. An issue that may arise in the context of India is the time required for obtaining a license to launch a new AIF (which is not a scheme of an existing AIF) in India. Practically, this may require at least a couple of months. Whereas, the need for Continuation fund will arise towards the end of the Legacy Fund’s tenure, and the GP does not have the benefit of time to wait for regulatory licenses.

Concluding Statements

In recent time, the instances of managers opting for a Continuation Funds has increased. One such instance is “Samara Capital” which transferred its stakes in three Indian companies to a Continuation fund namely “Samara Capital 2B”. This was a case of being one of the largest secondary transaction. The growing popularity could be attributed to the solutions it offers to two problems; firstly, providing liquidity to those investors who want to opt out of the AIF and secondly, an alternative exit route for investments bearing higher returns or those investments which have the potential to become high quality in some years. While the problems highlighted in this article denotes that Continuation Funds may not be the right option at times, but these issues can be navigated and careful planning by managers and investors can make Continuation Fun a viable option.  In the backdrop of Continuation Funds, the Continuation Fund’s constitutional document will include the important terms for onboarding the Lead Investor(s), any other new investors, and Existing Investors who elect to roll over into the Continuation Fund. These must frequently be carefully adapted to the needs of the Lead Investor(s), while retaining certain components for the Existing Fund for the comfort of the Existing Investors. The fund manager should communicate with Existing Investors early and be as transparent as possible to flush out any concerns in order to operate a successful Continuation Fund process and get an early indication of which investors are likely to want liquidity and which will provide consent to the Continuation Fund.

As previously said, Continuation Funds are highly customised products, and this article has only touched on some of the preliminary problems that must be addressed when selecting whether to employ a Continuation Fund and how to handle issues that may emerge along the road. While there are some technical and regulatory issues to be solved, the potential benefits of continuation funds outweigh the drawbacks. With the correct regulatory framework in place and market support, continuation funds have the potential to change the Indian investment landscape, benefiting investors, entrepreneurs, and the economy as a whole.

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