When a private equity firm establishes a continuation fund, the spotlight often lands on pricing, process, and investor dynamics. But lurking in the background is a technical – and often more contentious – issue on how to handle sponsor economics, particularly carried interest and employee co-investment.

These incentive mechanisms, essential to alignment in the legacy fund, don’t disappear when assets are rolled into a new vehicle. In fact, their complexity typically increases. How they are addressed can materially impact not just fairness and optics, but actual team motivation and retention. 

Maintaining Alignment

The core principle is simple: alignment between sponsors and LPs must be preserved. But applying that principle isn’t always straightforward. In some cases, maintaining alignment may mean diverging from how things were done in the legacy fund.

Carried Interest: Fairness, Timing, & Risk

But under a European waterfall, carry is locked until the entire fund meets its hurdle. That creates friction. If an asset is sold into the continuation vehicle before that hurdle is met, no carry is paid, raising questions about fairness to the deal team.

Clawback is another key concern. In cases where interim carry is distributed before final outcomes are known, clawback risk emerges – and must be carefully modeled, negotiated, and managed. 

Then there’s the issue of vesting in the new vehicle. Carry earned in the continuation fund generally merits a fresh vesting schedule, reflecting its own horizon. However, legacy fund vesting status shouldn’t be ignored.

Employee Co-Investments: Balancing Buy-In with Burden