Continuation funds burst onto the private equity scene only relatively recently but have quickly become established as an attractive part of the market. While they have been around for several years, there has been a step change in how aggressively they are being used.
Continuation funds involve an entity – whether a co-investment fund, another private fund or one of the other existing limited partners (LPs) – seeking to buy out existing LPs as the fund approaches its natural conclusion. While there is not necessarily any new capital coming in – existing LPs have a choice of either rolling their investment into the new fund or cashing out and taking profits.
Previously, such circumstances came up only occasionally, perhaps when portfolio companies within a fund were not ready for sale at the end of the planned lifecycle. A special purpose vehicle was set up to house assets, perhaps for three years, allowing further business development to be carried out or for market conditions to return to a more optimal state. The companies involved were not necessarily the crown jewels of a fund.
Over the last year or so, they have made up around half of the deal flow in secondaries and general partners (GPs) have started raising capital for dedicated funds. These are both huge shifts in such a short space of time.
This has all now changed. Continuation funds have become a way for GPs and their investors to hold on to companies longer, rather than selling them outright to another private equity firm or listing them on an exchange. Rather than the focus being on ‘problem’ companies, assets transferred to continuation funds are likely to be the best performers of the main fund and can therefore be considered a growth or momentum play.
While they are conceptually similar, in practice continuation funds differ significantly from traditional secondaries in terms of their risk profile. A typical secondary fund buys and holds pools of assets – so the resulting funds are highly diversified across perhaps several hundred companies.
By comparison, a continuation fund may contain 1-5companies and are therefore much more exposed to single-company risk. Existing LPs therefore need to take a view on whether they want to roll into a continuation fund that has a very different risk profile to the main fund. Such a concentrated fund may have volatility analogous to a single stock rather than a fund, so it would occupy a very different role within a client’s overall portfolio.
The creation of a continuation fund only increases the options of the LPs, so it should normally be seen as a positive development. The GP would only decide to hold on to an asset if it believes it can secure further economic gains. Therefore, the economics usually are better than they were in the original fund. If the LP disagrees, it is of course free not invest and seek liquidity instead.
In addition, a continuation fund is very likely to have a shorter liquidity timeframe than the original fund, often three or four years compared to the original ten. LPs are almost certainly not being asked to provide rescue funding for a floundering investment – they are typically being offered the option to roll over capital to extend exposure to a performing asset.
We believe this positive development for the industry as it provides additional liquidity, allows LPs to reconstruct their portfolios and prolongs exposure to the turbo-charged end of the investment J-curve.
Continuation funds present some new challenges for LPs to consider. They present potential conflicts of interest and there is no one-size-fits-all template for deals, as every transaction is unique. For example, has the fund fully paid carry, or is there some being rolled over? How much concentration risk, in a particular company or sector, are you willing to accept? At what point do you decline? Likewise, GPs must think about risk management and create rules for the fund, which are tasks they may infrequently have to consider.
Compared to a typical private equity fund, the fees are generally a bit lower and the preferences are likely to be more in the LPs’ favour. For example, there may be lower carry until it achieves its target internal rate of return (IRR) of perhaps 12% or 15%. However, if the continuation fund underperforms, the LPs may end up paying a higher carry than had the asset remained in the broader portfolio.
As it is likely that the best performing companies are transferred from the main fund to the continuation fund, asset prices are likely to appear high. In the absence of public market price discovery, a fair price needs to be determined for assets to be transferred. In some cases, a third-party is brought in to conduct a valuation but this potentially presents a conflict of interest. We believe a better arrangement is for the price to be set by another GP or professional investor entering the fund – the price it comes in at then sets the price for other investors entering or exiting. In addition, interests are better aligned when the GP itself rolls over a substantial stake at the same price as the new and old LPs.
Another issue to consider is the attributes of the GP, or GPs, involved in the continuation fund. The investor would have carefully vetted the original GP before making the initial investment. However, more than one GP can be involved in the continuation fund and the original one may no longer have a controlling interest. Investors would therefore need to be similarly comfortable with the new GP.
For each of these considerations, industry best practice due diligence has not been fully established. The growth in continuation funds has been so explosive over the last 18 months that there has been little time for the industry to catch up. So long as institutional investors are comfortable with the unfamiliar sources of risk that they present, continuation funds provide a valuable new tool to utilise when constructing and optimising portfolios.
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