Continuation Funds in PE: The Mechanics and Controversies of Rolling Portfolio Companies into New Vehicles

The second half of 2025 has crystallised a structural shift in private equity that was building through the post-ZIRP era: continuation funds are no longer an emergency exit for underperforming assets but are becoming a standard fixture of GP-led secondary transactions. Data from Evercore’s 2025 Secondary Market Review shows that GP-led transactions, the vast majority of which are continuation fund structures, accounted for 48% of the USD 87 billion in global secondary volume closed in the first three quarters of 2025, up from 32% in the same period of 2023. This surge is not merely a function of a sluggish IPO market; it reflects a deliberate recalibration of fund economics by General Partners (GPs) who are holding assets for 6-8 years rather than the traditional 3-5, and who face mounting pressure from Limited Partners (LPs) for liquidity. The Hong Kong market, while still a niche player in the global secondary space, is seeing increased activity as regional PE houses with portfolios in Greater China and Southeast Asia explore continuation vehicles to extend hold periods without triggering a full fund wind-down. However, the mechanics of these transactions—valuation methodology, LP rollover rights, and conflict-of-interest management—remain poorly understood outside a small circle of secondary specialists. This article unpacks the structural anatomy of a continuation fund, examines the regulatory guardrails that apply in a Hong Kong context, and addresses the persistent controversies around GP alignment and LP fairness.

The Structural Anatomy of a Continuation Fund

A continuation fund is a bespoke vehicle created by a GP to acquire one or more portfolio companies from an existing fund, effectively allowing the GP to extend its management of those assets beyond the original fund’s term. The transaction is structured as a sale from Fund I (the legacy fund) to Fund II (the continuation vehicle), with the GP typically rolling over a portion of its carried interest and co-investment into the new vehicle. The LPs of Fund I are given a binary choice: cash out at a negotiated valuation, or roll their pro-rata interest into the continuation fund. This structure is distinct from a traditional fund-to-fund sale, where the buyer is an unrelated third party, because the GP sits on both sides of the table.

The GP-Led Process and the Role of the Independent Advisor

The cornerstone of any defensible continuation fund transaction is the independent fairness opinion. Under the Institutional Limited Partners Association (ILPA) guidelines, which have been adopted as best practice by most Hong Kong-based fund managers, the GP must appoint an independent financial advisor to opine on whether the transaction price is fair to the LPs of the legacy fund. In practice, this advisor is typically a bulge-bracket investment bank or a specialist secondary advisory firm such as Campbell Lutyens or Evercore. The advisor runs a full marketing process—often called a “stapled process”—where the continuation fund’s proposed acquisition price is tested against bids from third-party buyers. If the GP’s continuation fund offers a price that is within a reasonable band of the highest third-party bid, the fairness opinion is generally supportable. If the GP’s bid is materially lower, the advisor must flag the discrepancy, and the GP risks a wave of LP opt-outs.

The Hong Kong Securities and Futures Commission (SFC) does not have a specific code governing continuation funds, as these vehicles are typically domiciled in the Cayman Islands or Delaware and are not themselves authorised funds under the SFO. However, the SFC’s Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the SFC Code of Conduct) applies to the licensed entity acting as the investment manager of the legacy fund. Paragraph 8.2 of the SFC Code of Conduct requires that a licensed person “avoid any conflict of interest” and, where a conflict is unavoidable, “ensure that its clients are fairly treated.” This general principle imposes a higher duty of disclosure on Hong Kong-licensed GPs managing continuation fund processes than on their unregulated counterparts in the Cayman Islands.

LP Rollover Mechanics and the “Stapled” Election

The LP rollover election is the most operationally complex element of a continuation fund. LPs in the legacy fund receive a detailed election package—typically a 60-90 page document—that includes the transaction’s summary term sheet, the fairness opinion, the valuation report, and the legal documentation for the continuation vehicle. The election period is usually 30-45 days. LPs who elect to roll over receive units in the continuation fund on a pro-rata basis, with the same economic terms (management fee, carried interest, hurdle rate) as the GP’s new investors. LPs who elect to cash out receive their pro-rata share of the sale proceeds, which are funded by the continuation fund’s capital commitments from new investors.

The key tension point is the valuation. The GP’s continuation fund must raise capital from new LPs—typically large secondary funds such as Coller Capital, Ardian, or Lexington Partners—and these new investors will only commit capital at a price that offers them an acceptable risk-adjusted return. The GP therefore has an incentive to price the transaction at a level that is low enough to attract new capital but high enough to avoid triggering a mass LP opt-out. Data from Setter Capital’s 2025 Volume Report indicates that the average discount to net asset value (NAV) for GP-led continuation fund transactions closed in 2024 was 8.5%, compared to 12.3% for traditional LP-led secondary sales of limited partnership interests. This narrower discount reflects the fact that the GP is effectively controlling the process and can structure the transaction to minimise dilution.

Valuation Controversies and the “Fair Value” Debate

The valuation of portfolio companies in a continuation fund transaction is the single most contentious issue, because it directly determines the distribution of proceeds between rolling LPs and cashing-out LPs. The GP must produce a valuation that satisfies three distinct constituencies: the fairness opinion advisor, the new LPs in the continuation fund, and the legacy LPs who are being asked to decide whether to roll or cash out. These three groups often have divergent views of what constitutes “fair value.”

The Mark-to-Market vs. Mark-to-Model Problem

Legacy fund valuations are typically calculated using International Private Equity and Venture Capital Valuation (IPEV) guidelines, which permit a range of methodologies including discounted cash flow (DCF), comparable company analysis, and recent transaction multiples. In a rising interest rate environment, the DCF approach tends to produce lower valuations than the comparable company approach, because the higher discount rate reduces the present value of future cash flows. This creates a structural mismatch: the GP may have been carrying the asset at a DCF-based valuation in the legacy fund’s quarterly reports, but the new LPs in the continuation fund may demand a valuation based on recent transaction multiples, which could be higher or lower.

The Hong Kong Monetary Authority (HKMA), in its Supervisory Policy Manual module SA-2 on “Valuation of Collateral and Other Risk Mitigants,” requires that valuations for regulatory capital purposes be “prudent and realistic.” While this circular applies directly to authorised institutions rather than PE funds, it establishes a regulatory expectation in Hong Kong that valuations should be supported by observable market data. A GP that uses a DCF valuation with subjective assumptions about terminal growth rates and discount rates faces a higher burden of proof when defending that valuation to Hong Kong-based LPs, particularly family offices and institutional investors governed by the HKMA’s Guideline on the Management of Investment Risks (GL-3).

The Secondaries Market as a Price Discovery Mechanism

The most robust defence against valuation controversy is a fully marketed auction process. In a well-structured continuation fund transaction, the GP hires a placement agent to run a competitive process among secondary buyers. The final price paid by the continuation fund is set at or near the highest bid received from a third-party buyer. This creates a market-clearing price that is, in theory, the most objective valuation available. In practice, however, the process is often less transparent than it appears. The GP controls the information flow, the timing, and the selection of bidders. A GP can structure the auction to favour a particular secondary buyer with whom it has a pre-existing relationship, or it can set a minimum price that eliminates all but the most aggressive bidders.

The SFC’s Code of Conduct requires that a licensed person “take all reasonable steps to ensure that its clients are not disadvantaged by any conflict of interest.” In the context of a continuation fund, this means the GP must disclose to legacy LPs the full details of the auction process, including the number of bidders, the range of bids received, and the identity of the winning bidder. Failure to do so exposes the GP to potential enforcement action under section 213 of the Securities and Futures Ordinance (SFO), which empowers the SFC to seek remedial orders for market misconduct or breaches of the Code of Conduct.

LP Alignment, GP Incentives, and the Principal-Agent Problem

The fundamental tension in a continuation fund is the principal-agent problem: the GP is both the seller (acting on behalf of the legacy fund) and the buyer (acting through the continuation fund). This dual role creates inherent conflicts that cannot be fully eliminated, only managed through structural safeguards. The most controversial safeguard is the GP’s decision to roll over its carried interest and co-investment into the continuation fund, which is intended to signal alignment but can also be structured in ways that dilute legacy LPs.

The Rollover of GP Carried Interest and Co-Investment

In a typical continuation fund, the GP rolls over 100% of its accrued carried interest from the legacy fund into the new vehicle, along with any co-investment capital it had committed to the legacy fund. This rollover is presented as evidence that the GP has “skin in the game” and is aligned with the rolling LPs. The reality is more nuanced. The GP’s carried interest in the legacy fund is an unrealised, contingent asset; rolling it into the continuation fund does not require the GP to put new cash at risk. The GP is merely deferring its potential payout. The true alignment test is whether the GP commits new capital to the continuation fund alongside the new LPs. Data from a 2024 study by the Global Private Equity Council (GPEC) showed that only 34% of continuation fund transactions included a GP co-investment of fresh capital exceeding 2% of the fund’s total commitments. The remaining 66% relied solely on the rollover of existing carried interest.

The SFC’s Guidelines on the Management of Conflicts of Interest by Licensed Persons (published in 2019 and updated in 2023) explicitly address this point. Paragraph 4.3 of the guidelines states that a licensed person “should not rely solely on the rollover of existing interests as evidence of alignment with clients.” The SFC expects the GP to demonstrate that its economic interest in the continuation fund is proportionate to the risk it asks LPs to assume. A GP that rolls over carried interest but does not invest new capital may be seen as having an asymmetric incentive structure: it benefits from upside through its carried interest but bears no downside risk if the continuation fund underperforms.

The “Two-Tier” Fee Structure and the Net IRR Impact

Continuation funds typically charge a management fee of 1.0% to 1.5% of committed capital, which is lower than the 1.5% to 2.0% charged by primary buyout funds, but higher than the zero-fee structure of a fund in its harvest period. The net effect on LP returns is significant. Consider a legacy fund that is in year seven of its ten-year term and has stopped charging management fees on realised capital. When that fund rolls its remaining assets into a continuation fund with a five-year term and a 1.25% management fee, the rolling LPs effectively incur an additional 6.25% in fees over the life of the continuation fund (1.25% × 5 years). This fee drag reduces the net internal rate of return (IRR) for rolling LPs by approximately 150 to 200 basis points, depending on the gross return assumptions.

The HKMA’s Guideline on the Management of Investment Risks (GL-3) requires that institutional investors in Hong Kong, including the Exchange Fund and the Mandatory Provident Fund (MPF) schemes, conduct a “comprehensive assessment of all fees and expenses” before committing to any alternative investment vehicle. For a Hong Kong-based MPF trustee evaluating a continuation fund proposal, the net IRR impact of the two-tier fee structure must be explicitly modelled and disclosed to the scheme’s investment committee. Failure to do so could constitute a breach of the trustee’s fiduciary duties under the Mandatory Provident Fund Schemes Ordinance (Cap. 485).

Regulatory and Tax Considerations for Hong Kong-Based GPs and LPs

Hong Kong’s tax regime for private equity is relatively favourable, but the use of continuation funds introduces specific complexities that require careful structuring. The key issues are the tax treatment of the sale from the legacy fund to the continuation fund, the residency of the continuation vehicle, and the application of the unified profits tax exemption for offshore funds under the Inland Revenue Ordinance (IRO).

The Taxable Event: Sale vs. Reorganisation

The transfer of a portfolio company from a legacy fund to a continuation fund is typically structured as a sale, which creates a taxable event for the legacy fund. If the legacy fund is domiciled in the Cayman Islands and is managed from Hong Kong, the question of whether the gain on sale is subject to Hong Kong profits tax depends on the nature of the asset and the activities of the fund manager. Under section 20AK of the IRO, a fund that is “qualifying” (i.e., not a “specified fund” that is primarily engaged in short-term trading) is exempt from profits tax on gains from transactions in “qualifying assets,” which include shares in private companies. However, the exemption is not automatic. The fund must satisfy the “central management and control” test, which requires that the investment decisions are made outside Hong Kong or that the fund’s profits are derived from offshore activities.

A continuation fund transaction that is structured as a reorganisation under Cayman law—where the legacy fund contributes its assets to the continuation fund in exchange for units, rather than selling them for cash—may be treated as a tax-free rollover under Cayman law, but the Hong Kong tax analysis is independent. The Inland Revenue Department (IRD) will look through the legal form to the economic substance. If the GP is based in Hong Kong and the investment team makes the decision to transfer the assets, the IRD may argue that the gain is sourced in Hong Kong and is therefore subject to profits tax at the 16.5% rate. The prudent approach is to obtain a tax ruling from the IRD before closing the transaction, a process that typically takes 6 to 12 months.

The Residency of the Continuation Vehicle and the “Managed in Hong Kong” Risk

Most continuation funds are domiciled in the Cayman Islands or Delaware, but the GP’s management team is usually based in Hong Kong. This creates a “managed in Hong Kong” risk for the continuation fund itself. Under the IRO, a company that is “managed and controlled” in Hong Kong is considered resident in Hong Kong for tax purposes, even if it is incorporated offshore. If the IRD determines that the continuation fund’s investment committee meets in Hong Kong, or that the GP’s Hong Kong office makes the key investment decisions, the fund could be deemed a Hong Kong tax resident. In that case, its income—including carried interest and management fees—would be subject to Hong Kong profits tax.

The SFC’s Licensing Handbook (Chapter 5) requires that any person carrying on a business of “asset management” in Hong Kong must be licensed under the SFO. A GP that manages a continuation fund from Hong Kong without a Type 9 (asset management) licence is in breach of the SFO and faces potential criminal liability. This is not a theoretical risk: in 2023, the SFC took enforcement action against a Hong Kong-based fund manager for operating an unlicensed asset management business through a Cayman vehicle, resulting in a fine of HKD 4.5 million and a three-year ban on the responsible officer.

Actionable Takeaways for GPs and LPs

1. GPs must run a fully marketed auction process with a minimum of three independent bids to satisfy the SFC’s conflict-of-interest requirements under Paragraph 8.2 of the Code of Conduct, and must disclose the full bid range to legacy LPs.

2. LPs evaluating a rollover election should model the net IRR impact of the two-tier fee structure—typically 150-200 bps of drag—and compare it to the projected net IRR of a cash-out plus reinvestment in a primary fund with a lower fee burden.

3. Hong Kong-based GPs should obtain a tax ruling from the IRD on the profits tax treatment of the sale from the legacy fund to the continuation fund, and should ensure that the continuation fund’s investment committee meetings are held outside Hong Kong to avoid managed-in-Hong Kong residency.

4. GPs should commit fresh capital—not merely roll over carried interest—to the continuation fund, with a minimum of 2% of total commitments, to evidence alignment under the SFC’s 2023 Guidelines on Conflicts of Interest.

5. LPs should request a copy of the fairness opinion and the full auction process memorandum before the election deadline, and should engage independent legal and tax counsel in Hong Kong to assess the implications of the rollover under the IRO and the SFO.