UK: Travers Smith's Alternative Insights: ILPA Guidance On GP-Leds

A regular briefing for the alternative asset management industry.

Continuation funds: how will the 2023 ILPA guidance be received?

While the market awaits final SEC rules on "continuation funds" (also known as GP-led secondaries), the dust is already starting to settle on ILPA's revised guidance. ILPA, a leading industry association for LPs, has built on its previous guidance, but is now more prescriptive in its recommendations. (Our detailed note on the new ILPA guidance is here.)

However, while everyone agrees that effective conflict management is the key to a successful process, ILPA also acknowledges that no two transactions are exactly the same. Too much prescription, at least in relation to terms, could constrain rather than enhance alignment.

It is clear that the main process point that the revised guidance addresses is an important one for investors: LPs have been clear that these deals pose challenges for them. As two academics, Kobi Kastiel & Yaron Nili, have catalogued in a forthcoming paper, some LPs find it difficult to make investment decisions on individual assets – a departure from their usual role of allocating capital to funds or managers on a blind pool basis – and many investors lack the infrastructure to make such decisions quickly. That problem is particularly acute for US state pension funds subject to ERISA rules. That may be one of the reasons that 80-90% of investors typically elect to cash out rather than roll over into the continuation fund.

A number ILPA's of recommendations seek to address that. For example, the guidelines emphasise the importance of complete disclosure to all investors. There is quite a lot of prescription in the required disclosures, and some of the information – for example, the performance of prior continuation funds – may not be particularly relevant. In order to make sure that LPs have the right information, GPs should focus on quality over quantity and concentrate on providing relevant information with appropriate context.

Timing is also crucial. Reiterating its 2019 guidance, ILPA recommends that LPs should have at least 30 calendar days (or 20 business days) to make roll or sell decisions. In practice, most well-run GP-led processes provide for this timescale at a minimum, and it is clearly important to be responsive to the needs of the (often diverse) investor base.

But the role of the Limited Partner Advisory Committee, or LPAC, is also at the heart of the ILPA guidance – even though Kastiel and Nili report that many LPs who are not represented on the LPAC have concerns. Some investors have pointed out that the LPAC is a body created by the GP, the members of the LPAC are usually those with the closest and longest-standing relationship with the GP, and LPAC members do not generally owe duties to other investors. Nevertheless, ILPA rightly recognises that the LPAC must play a key role in any effective process, given the difficulties in communicating with all LPs at all stages of the process. It urges regular and fulsome communication with the LPAC, and reflects the practical reality that LPAC consent is almost always required to help manage the conflicts of interest.

ILPA's revised guidance also includes some important recommendations on terms. For example, their view is that 100% of accrued carry should be rolled into the continuation vehicle. That reflects a common market practice as GPs are keen to demonstrate conviction in the underlying asset(s). For funds with European-style carried interest waterfalls, where carry may not crystallise on any one particular deal, many GPs show enhanced "skin in the game" through higher GP commitments (funded from balance sheet, by third party minority capital and/or co-invest from other fund vintages). ILPA suggests that management fees should be proportionate to the operational requirements of managing the relevant assets, and this also aligns with market norms.

Perhaps most notably, for LPs that choose to roll over into the new vehicle, ILPA has expanded its 2019 definition of the "status quo" option. This should entail no increase in management fee, no re-basing of carried interest, no change to the rate of carried interest, and no crystallisation of carry. These may be challenging in practice and may not always be in the best interests of rolling investors, so the level of prescription here will be tested in real-world deals.

Price discovery is, of course, key. ILPA recommends that a competitive process should be run to ensure a fair price, which includes third party price validation. Use of fairness opinions is already embedded in most GP-led processes and is a key part of managing the inherent conflict of interest that arises for the GP.

The new ILPA guidance should help to confirm the role of GP-led deals, which – in the right circumstances, and with appropriate management of conflicts – can provide a win for all stakeholders. It is helpful in its codification of existing market practices, but certain recommendations may be difficult to apply in practice. It is to be hoped that the market does not default to a "tick box" approach, rather than a considered application of the principles: transparency, disclosure, fairness and alignment.

The academic paper mentioned is Kobi Kastiel & Yaron Nili, "The Rise of Continuation Funds" (Working Paper, forthcoming in University of Pennsylvania Law Review, 2024).

Originally published by 07 July, 2023

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