Continuation Vehicle: Holding an Asset Past the Fund's Life

A continuation vehicle is a new fund set up to buy one or more holdings from an existing fund that is running out of contracted term, with the same manager standing on both sides. Existing investors are offered a choice: take the cash the sale produces, or roll into the new vehicle. The manager sets the price it sells at and the price it buys at, and that conflict is structural.

The conflict belongs at the front of any description of this transaction. One party is choosing what it sells for and what it pays. Every valuation, every opinion, every consent and every deadline in the transaction exists on account of that one fact, and none of them is intelligible before it is said. With the conflict named first, the process around it becomes something that can be tested; with the process named first, it becomes a checklist to be accepted. A reader handed the process first hears reassurance where a problem was.

What problem is a continuation vehicle answering?

Start with something ordinary. A shopkeeper takes a five year lease on a stall and builds a business inside it. In year four and a half the business is finally working, and the lease has six months left. The landlord did not agree to wait, and the customers did not agree to buy the business by a date. Two clocks, one commercial and one contractual, and they do not run together. Everything difficult about that situation comes from the fact that the person who has to solve it is the same person the deadline is inconvenient for.

A closed-end private fund has exactly this shape. Nilgiri Growth Partners Fund II, invented, was settled with a contracted termThe end date a fund's own documents set for its life, before any extension is taken. of ten years from its final close. At its record date, the end of Fund II Year 9 Quarter 2, six quarters of that term remain and five of its nine holdings have not been sold. The five unsold holdings are carried in the fund's own reporting at Rs 2,82,00,00,000 in total. The fund has a date and the businesses do not, and a continuation vehicle is one answer to the gap between them.

The general statement is much less useful than the list. Here is what is actually sitting there at the record date.

Two readings of that table matter here. The first is the total: at the record date Nilgiri Growth Partners Fund II, invented, carries Rs 2,82,00,00,000 of reported value against Rs 1,80,00,00,000 of cost still in the ground, being 1.57 times that remaining cost, and it has six quarters in which to turn all of it into money. The second is the concentration inside it. Holding 4 alone is Rs 1,08,00,00,000 of that Rs 2,82,00,00,000, being 38.3 per cent of the reported value of everything this invented fund still held at the end of Fund II Year 9 Quarter 2. What is done about holding 4 is most of what is done about the fund's remaining problem. Holding 6 is carried at Rs 21,00,00,000, under a fifth of the same figure.

The reported figure of Rs 1,08,00,00,000 is a carrying value, and how a private fund strikes one is set out under the valuation of unsold holdings. Two extensions of one year each are available to this fund under its own documents, the first at the manager's election with the prior written consent of the investor advisory committee and the second with the consent of investors holding more than half of commitments by value. Neither has been taken at the record date. Both extensions are set out under fund term and extensions.

What is a continuation vehicle, and what actually changes hands?

Strip away the vocabulary and the transaction is a sale. A new fund is set up. The new fund buys one or more holdings out of the existing fund. The existing fund receives money for what it sold, exactly as it would if a stranger had bought the position, and the money is available to be paid out to its investors. The holding itself does not change: the same company, the same board seats, the same shareholders agreement and the same seven reserved matters. The vehicle standing above the company changes, and so does the set of people whose money is inside that vehicle.

So a continuation vehicleA new fund set up to buy one or more holdings from an existing fund that the same manager runs. is a new fund set up to buy one or more holdings from an existing fund that the same manager runs. Nothing about the business moves; the wrapper around it is replaced, and the clock the wrapper carries is replaced with it. That last part is the whole commercial point. The old wrapper had six quarters left. The new one starts its own term at nought.

Three things pass across, and a reader who lumps them together loses the argument later. First, the position itself, meaning the shares in the portfolio company and every contractual right attached to them. Second, money, from the new vehicle to the old fund, and that money is the price. Third, and this one is easy to miss, the future of the arrangement: a new term, a new management fee arrangement and a new carried interest arrangement, all of which attach to the new vehicle and none of which are the old fund's terms carried across.

Who is standing on each side of the price?

Three parties are named in any description of this, and one of them is counted twice. The selling fund is Nilgiri Growth Partners Fund II, invented, whose twelve investors have paid in Rs 4,80,00,00,000 against Rs 5,00,00,00,000 of total commitments. The buying vehicle is new, with whatever investors elect to rollKeeping the exposure by moving it into the new vehicle instead of taking cash. into it plus whoever else the manager brings in. And Nilgiri Alternatives Advisors Private Limited, invented, is the investment manager of the first and would be the investment manager of the second.

The arrangement is not three parties negotiating; it is two vehicles and one party occupying a position on each side of the table. Draw it any other way and the picture hides the only thing worth seeing. In an ordinary sale of a position to somebody outside, the buyer pushes the price down because every rupee is its own money, and the seller pushes it up for the same reason, and the number that survives that pushing is what people mean by an arm's length price. In a continuation vehicle there is nobody on the other side. Nobody is pushing.

Why is the conflict structural rather than an accusation?

Because it exists before anybody has done anything at all. Nobody has to behave badly for it to be there. The moment a manager proposes to sell a holding to a vehicle it would itself run, it has taken a position on both sides of a number, and that is true of the most scrupulous manager alive on the most carefully documented transaction ever attempted. The conflict is a property of the structure and not a judgement about anybody's conduct, and confusing those two is what makes readers either dismiss the whole arrangement or dismiss the whole concern.

The price itself is the part that resists being felt. Look at what it actually does. Suppose the price is Rs 1,08,00,00,000. Every rupee added to it is a rupee more for whoever takes the cash, and a rupee more that whoever rolls has effectively paid for the same business. Every rupee taken off it runs the other way. Nothing outside the picture changes: the company does not become better or worse, the reported value of the fund's other four unsold holdings does not move, no third party gains or loses anything. The price is a transfer inside one manager's own set of investors, and the manager sets it.

What answers the conflict, and in what order does it run?

Four things are usually put around a transaction of this shape, and it is worth saying at the outset what they are and are not. Every one of them is a control on a conflict that is still there afterwards, and none of them removes it. A seatbelt does not make a crash impossible. A seatbelt changes what a crash does to the person wearing it. The smaller claim is the only one any of these four can honestly make.

The first is an independent valuation agentAn outside firm that values a fund's unrealised holdings on a fixed timetable, rather than the manager valuing them itself.. Nilgiri Growth Partners Fund II, invented, already has one for its ordinary reporting: Palani Valuation Advisors LLP, an invented limited liability partnership, strikes the value of everything unsold on the fund's fixed timetable, and the Rs 1,08,00,00,000 on holding 4 is a figure of that kind. A value struck outside the manager is a better starting point than a value struck inside it. The outside value is still an estimate of a business nobody has sold.

The second is a fairness opinionA written view from somebody outside a transaction on whether the price in it is defensible.: a written view from somebody outside the transaction on whether the price is defensible. Notice how carefully the definition has to be phrased. A fairness opinion does not say the price is correct. Nobody can say that about an unlisted business before it is sold. The opinion says the price falls inside a range a reasonable person could defend. The claim is genuinely useful and much narrower than what a reader tends to hear.

The third is the consent of the investor advisory committee. Most readers go wrong there, and it is taken apart below on its own. The fourth is the cash option, and it is the only one of the four that puts something on the other side of the table rather than merely observing the price. The whole sequence runs like this.

What can the investor advisory committee actually do?

Here is the single most common misreading in this subject, and it costs a reader the ability to check anything. There are two committees with similar sounding names and almost nothing in common, and a reader who merges them believes somebody is checking something that nobody is checking.

The investor advisory committeeA committee drawn from a fund's own investors that consents on conflicts and on valuation policy. The committee does not approve investments. is drawn from the fund's own investors. In Nilgiri Growth Partners Fund II, invented, investor 1 holds a seat on it under its side letter, and the committee's own costs are borne by the fund as an operating expense. The committee consents on conflicts, on valuation policy, on the first of the fund's two one year extensions and on changes to investment policy. The committee consents; it does not approve investments, and it has no power to refuse one.

The investment committeeThe body inside a manager that approves each investment and each realisation the fund makes. is the body inside the manager that approves every investment and every realisation, and four of its five members are drawn from the manager. The investment committee is the body which decides. Its members are not drawn from investors, they do not answer to investors, and nothing an investor does reaches inside the committee.

What makes the cash option real rather than decorative?

The cash optionThe right to be paid out instead of rolling, which is what turns an election into an actual choice. is the right to be paid out instead of rolling. The cash option is the only one of the four controls that puts a live counterparty on the other side of the price. Think about why. An investor who thinks the price is too low takes the cash and buys nothing, and the vehicle raises less. An investor who thinks it is too high takes the cash and is delighted to. Either way the price is being tested by somebody with money at stake. An ordinary sale has that test built into it and a continuation vehicle otherwise lacks it.

Without a genuine cash option, an investor who wanted out would be carried into a new vehicle on new terms by default, and the consent that was obtained would mean very little. That is the sentence the whole block turns on. A consent given by people who had nowhere else to go is a signature, not a decision.

Now the harder question. How can an option be unreal without anybody saying anything untrue? Two ways, and neither of them requires a false statement. The first is price: set the number low enough and taking the cash is obviously the worse branch, so the election is nominally open and practically shut. The second is time: set the response window short enough and an institution that needs an internal approval before it can act cannot get one, so the option exists and cannot be exercised. An option that cannot be taken is not a counterparty, and a price it never tested has not been tested.

The document an investor actually receives matters more than any summary of it, and it is short. The notice carries a holding, a price, two boxes and a date, and the date is doing as much work as the boxes.

What would a full cash election do to the selling fund's reported numbers?

Take the counterfactual to its cleanest corner and suppose all twelve investors of Nilgiri Growth Partners Fund II, invented, took the cash at Rs 1,08,00,00,000. No such election has been offered. Running the arithmetic anyway shows something a reader usually gets wrong about what a realisation does.

The fund has drawn Rs 4,80,00,00,000 from its investors and has distributed Rs 4,38,00,00,000 back to the record date. Add Rs 1,08,00,00,000 and cumulative distributions become Rs 5,46,00,00,000. Take the same Rs 1,08,00,00,000 out of the Rs 2,82,00,00,000 the fund still carries and the residual falls to Rs 1,74,00,00,000. Both readings are then divided by the same denominator, the Rs 4,80,00,00,000 of capital paid in.

Read the last row before anything else. Nothing was created. Rs 1,08,00,00,000 moved from the column of what is still an estimate into the column of money that has actually been paid, and the total is unmoved at 1.5000. The two middle readings are usually written to two places as 0.91 becoming 1.14, and 0.59 becoming 0.36, and it is worth carrying the unrounded figures for a moment because 1.1375 plus 0.3625 is 1.5000 exactly while 1.14 plus 0.36 is 1.50 only because both roundings happened to be kind.

One consequence is worth naming because it is the reason a manager would care. Before this, the fund had paid back Rs 4,38,00,00,000 of the Rs 4,80,00,00,000 its investors put in, a shortfall of Rs 42,00,00,000 on returning their capital. After it, Rs 5,46,00,00,000 has been paid back. The Rs 4,80,00,00,000 is cleared with Rs 66,00,00,000 to spare. Where the Rs 66,00,00,000 goes next turns on the fund's accrued preferred return, and this fund has never stated one.

What is a rolling investor actually agreeing to?

A rolling investor's question is different from everybody else's. An investor that rolls keeps the same business. The rolling investor keeps nothing else. The term is new, the management fee arrangement is new, the carried interest arrangement is new, and the value the price fixes becomes the point from which any later profit on that holding is measured. An investor who rolls is agreeing to a set of terms rather than to a business it already knows, and at the moment the election notice arrives those terms are the part it has read least.

Where to look is settled: the new vehicle's own documents are the object, not the price. A reader who spends all their attention on whether Rs 1,08,00,00,000 is the right number and none on the new vehicle's terms has audited the smaller half of the decision.

How does somebody actually read one of these when it lands?

Imagine investor 5 of Nilgiri Growth Partners Fund II, invented, a fund of funds with Rs 50,00,00,000 committed, being 10.0 per cent of the fund's Rs 5,00,00,00,000 of total commitments. An election notice arrives. Somebody there has a fortnight, or whatever the notice allows, and a committee of their own to get through. What do they actually do with the paper?

Four things get done, and none of them is arguing about the price. First they read the notice for the conflict, and if the notice does not name it they write it at the top themselves. A process list with no conflict at the head of it cannot be assessed. Second they check whether the cash branch is takeable: is the window long enough for their own approval to run, and is the number one a reasonable person could accept. Third they read the new vehicle's documents rather than the valuation. The valuation is one number they cannot verify, and the documents are the arrangement they will live inside for years. Fourth, and this is the part that gets skipped, they work out what taking the cash actually does to their own position. A distribution they did not plan for is money that has to go somewhere.

Nobody can settle whether the price is right about an unlisted business before it is sold. The practitioner's question is whether the choice in front of them is a real one, and what the branch they pick commits them to. That reframing is most of what separates somebody who can read one of these from somebody who can only react to it.

Two more readers use the same document differently. A lender that has money out against the fund, or against an investor's interest in it, reads the notice for one thing: cash is about to move, and it wants to know how much and to whom. An analyst covering the manager reads it as evidence about the manager, not about the company, and the question it settles is how this manager behaves when its own contracted term is running out.