Growth is surging for continuation funds, where private equity firms roll over assets and investors from funds nearing the end of their lifecycle, thanks to an image makeover during the pandemic.
Previously, the funds were perceived as an outlet for general partners who were forced to hang on to an undesirable asset they couldn’t sell by the end of the standard 7- to 10-year life of a PE fund.
But that perception shifted when the initial public offering market dried up during the pandemic, says Molly Diggins, a partner at Monument Group, a Boston-based private placement firm for middle-market PE funds. With the IPO option shut down, private equity firms formed continuation funds to hang on to the companies they considered as prized assets and develop them further.
“Continuation funds really took off during the pandemic, when previously they were sort of frowned upon,” says Diggins, whose firm provides advice on general partner-led restructurings. Now, even with the resumption of IPOs, PE firms are forming continuation funds to manage last remaining assets.
“We’re seeing more and more and more and more of these, and it’s now viewed as a real management tool for general partners to review their portfolios, keep the best assets for a longer term if they see potential additional growth and profit, and at the same time to offer limited partners some liquidity or options,” Diggins says. “I think it’s definitely no longer frowned upon. LPs understand that these can be really good investments.”
From the fund investor’s point of view, there are two specific scenarios where a continuation fund can help boost the value of a portfolio company, says Samer Ghaddar, deputy chief investment officer of the $50 billion Arizona State Retirement System. In the first case, some portfolio companies have been affected by Covid-19, both with their sales and cash flow, so selling them at their current market valuations would be against the best interests of the limited partners. Secondly, some PE funds either have passed their investment period and cannot call capital, or they have invested all of their capital and the continuation funds are the only way to do add-on acquisitions for the portfolio company. In these cases, a continuation fund is a good way for the general partner to raise new capital and allow the fund time to grow the portfolio company to its potential.
Middle Market Interest
Even before the pandemic, secondary market transaction totals indicated that the appetite for continuation funds was growing. Secondary market transactions as a whole grew from $74 billion in 2018 to $85 billion in 2019, before falling to $62 billion in 2020 due to Covid-19, according to Mercer. The portion of secondary market transactions that arose from GP-led restructurings—the category that continuation funds fall under—had reached nearly 50 percent by 2020, up from less than 5 percent in 2013, according to banking advisor Evercore.
Middle-market PE firms have been especially busy in forming continuation funds.
Part of the reason behind the rise of continuation funds is the desire of long-time PE fund investors to cash out, says Steven Alecia, co-founder of Gen II, a private equity fund administrator.
“I think existing LPs wanting liquidity is creating this market a little bit, because existing LPs in an existing fund that have been in that fund for a long time probably want some liquidity,” Alecia says. “And this seems to be a very good way for the sponsor to drive that, so they’re giving their existing LPs liquidity, but they’re also bringing in new LP capital to support the asset.”
“From the GP’s perspective, giving existing LPs the chance of liquidity as well as giving existing LPs or a new LP the potential to invest into this asset; it seems like a win-win,” he says.
An extended run of growth for the overall economy has also contributed to the rise of the funds, says Todd Boudreau, a partner in the Morrison & Foerster law firm in Boston, who has worked both with general partners and limited partners on continuation fund deals. “It’s a product of an economy that’s done really well over long period of time, and it’s brought up the need to have some of these long-term fund options,” he says.
The fund investors do need to wade through the conflicts of interest that can arise for the fund manager, who is on both sides of the transaction to move the asset into the continuation fund, Diggins says. So the investors need to determine whether the valuation of the asset company is fair.
“The toughest piece of this is how general partners value that asset, because they’re essentially selling it to themselves,” Alecia says.
Performing this type of due diligence can be a new experience for the investor, who normally relies on the general partner to make the investments and come up with the price. With a continuation fund asset, larger limited partners may have the staff to determine a valuation on their own, Diggins says. And in some cases, typically for the larger PE firms, the general partner will seek a third-party confirmation of the GP’s valuation of the asset company to assuage investors who don’t have the resources to value the asset themselves.
Usually the general partner will put its valuation of the company to a vote for approval from the fund’s limited partners advisory committee, or LPAC, for the fund to be wound down.
For the limited partners who are cashing out, new LPs from the secondary market buy them out; the new LPs join the rolling-over LPs as investors in the continuation fund. The ultimate price received by the exiting LPs is set by the secondary market. “There’s actually an efficient market that’s determining the value of these LP interests,” Boudreau says.
While most continuation funds are set up for just one asset, some managers may establish continuation funds with three or four assets, Boudreau says. As with the single-asset scenario, part of the fund manager’s objective would be to provide liquidity to investors who want it, while bringing in fresh capital through the secondary market investor.
“It gives the manager the ability to not sell the asset prematurely based on the life of the fund term and continue to build the company to make it more valuable,” Boudreau says. “It’s not the GP making a determination of the value and forcing that on the LP; it’s giving the LP an opportunity to cash out or to roll over.”
More Work for LPs
Investors in a continuation fund have more work to do than if they were to invest in a traditional PE fund, Alecia says. That’s because they have to perform their due diligence on the asset or assets in the fund, where with a traditional fund their due diligence is focused on the fund manager.
“It’s probably a different type of diligence that the LP has to have to look at, to really understand that asset as opposed to putting money into a co-mingled fund and relying on the sponsor to make those selections into those assets over time,” Alecia says.
Some investors might want to know more about the asset company in the continuation fund–its operations or its property holdings, for example—as with the typical due diligence involved in buying a company, Boudreau says.
Another consideration for the potential investors in a continuation fund is the management and carry fees to be charged by the fund manager. Whether the carry fee was charged in the old fund depends on whether the fund manager met its return hurdles, and the management fee may have been reduced or even dropped to zero toward the end of the fund’s life, Boudreau says.
Generally, the management and carry fees charged to investors in a continuation fund are lower than with a new PE fund because the fund manager isn’t making any new investment decisions; it’s just managing the asset.
Another key difference between a continuation fund and a traditional PE fund is that the investor’s risk is concentrated in a single asset or handful of assets, and not spread out over a larger number of underlying assets as it would be in the traditional fund, Alecia says. The vast majority of continuation funds are created for a single asset. Continuation funds are typically set up for a shorter period—2 to 6 years– than the 10-year typical life of a new PE fund.
From the limited partner perspective, continuation funds are similar to co-investments, but the LP doesn’t have to contribute to the management or oversight of the asset in a continuation fund. And unlike a typical co-investment arrangement, the LP in a continuation fund pays a management fee.
Just as they would with a traditional fund, prospective investors in a continuation fund are going to ultimately make their decision to invest based on the expected investment rate of return and risk profile compared to other potential investments, Alecia says.
For the investors, on the plus side for continuation funds: The LPs are probably getting a free look at a good investment, Alecia says. “The sponsor has been intimately involved with that asset for quite a bit of time, and the LPs are trusting that that sponsor knows that asset inside and out and feels good about the value that they can still add to it over time.”
Another plus for the investors in a continuation fund: They are potentially getting to buy in at favorable terms, such as lower fees. For example, an anchor LP who has promised to invest in the next fund raised by the PE firm creating the continuation fund may be offered favorable terms in the continuation fund as part of a package deal, Alecia says.
This kind of package deal for favorable terms, also known as stapled commitment, can introduce another potential conflict that could hurt the GP’s case that the continuation fund has been established with strictly arms-length transactions. The fund manager has to show investors why they would want to continue to hold assets over from the original fund rather than simply exit at the end of the fund’s life. Also, it has to prove that it isn’t extending the life of a bad asset just to gather more management fees.
Overall, the fund manager has to make sure that the transfer of the company or companies to the continuation fund, the fees to investors and the pricing of the assets “is done at arm’s length and they’re not over allocating or changing the economics in a way that’s disproportionate or unfair to their investors,” Boudreau says.
Previously, more than five years ago, before the recent rise in continuation funds, investors in a PE fund with one asset remaining might be stuck with the general partner’s decision about how to sell or move that asset, Boudreau says.
“If the manager or LPAC approved it, the prior fund would get whatever that valuation was at that time, and that was it,” he says. “You couldn’t necessarily say: ‘I don’t want to cash out at that valuation; I want to stay in.’ It also gave the manager fewer options to realize the best outcome. Selling or moving wasn’t always the best option, and that could be problematic.”
Now, continuation funds are giving that investor the choice of whether or not to cash out or stay in. “I think that part of the market has become a lot more equitable,” he says.