Regulatory Considerations for Continuation Funds

High interest rates, market volatility, and various other macroeconomic factors continue to push asset managers to adapt to successfully carry out their investment strategies, find liquidity for their investors, and keep and deploy capital in attractive assets.

Adaptability for asset managers, especially those in illiquid private markets, includes the increased popularity of general partner (GP)-led secondary transactions. In these transactions, a sponsor arranges for a new investment vehicle to acquire assets from another sponsor-managed vehicle to continue the control and management of assets that are either difficult to exit or not ready to be liquidated. (The new funds are also commonly referred as continuation funds.)

This practice is not entirely new, but it continues to gain popularity with asset managers given the difficult environment in capital raising and limited liquidity. The U.S. Securities and Exchange Commission (SEC) has taken notice of advisers’ use of continuation funds and the conflicts of interest and risks of potential investor harm that can come with continuation funds.

Continuation fund risks

In September 2023, for example, the SEC brought an enforcement action against an adviser for breach of their fiduciary duty when the adviser transferred assets between funds without adequately disclosing conflicts of interest to investors or the fund’s limited partner advisory committee (LPAC), obtaining investor consent, or allowing investors to liquidate or exit their investments in accordance with relevant fund terms.

Putting the uncertainty of the new administration and SEC leadership aside, conflicted transactions are core to the fiduciary duty of registered investment advisers and will continue to be scrutinized by present and potential investors, especially on the institutional side. It is also worth noting that the 2025 Exam Priorities, recently released by the SEC Division of Exams, specifically references adviser-led secondary transactions and transactions between private funds as a focus priority.

The main regulatory risk concerning continuation funds is simple: one fund and/or adviser getting an advantage at the expense of another fund. This can be attained through the transfer of an asset that disproportionately benefits one fund, one-sided valuations, and unfair expense allocations, among other things. Many funds participating in these affiliated transactions are considered principal accounts due to advisers’ ownership, also triggering the requirements of principal transactions, as outlined under Section 206(3) of the Advisers Act.

Our guidance

To adequately address regulatory risks concerning continuation funds, the following steps should be considered. Some of these follow the spirit of the, for now, defunct Private Fund Adviser Rules (PFAR) that can still serve as a roadmap for regulators and advisers to meet the fiduciary duty required under the Advisers Act:

• Review funds’ governing documents to ensure all requirements concerning conflicted transactions and engagement of LPACs are satisfied.
• Evaluate and document the rationale of the investment decision and how it is beneficial, consistent with the adviser's fiduciary duty, and within the investment mandate to all funds participating in the transaction.
• Confirm all elements of the adviser’s valuation policy are met and engage a third-party to determine the value of asset(s) subject to the transaction with either a fairness or valuation opinion.
• Ensure that expenses relating to the transaction are allocated in a way that is fair and consistent with disclosures and fund governing documents.
• Consider seeking written consents from LPACs or investors that outline the rationale of the investment, how they benefit all participants, and the potential conflicts of interest in good faith, even when the transaction is not considered principal, or Section 206(3) of the Advisers Act.

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The compliance environment has never been more complex or demanding. We can help you to navigate the evolving regulatory landscape while considering the complexity of your firm’s unique compliance requirements. ACA Signature can help.

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