How a small innovation may permanently alter Private Equity investing

 

Possibly the ‘Best of the Best’

 

The development of funds intended to extend the economic gains of performing assets has been a major trend in private equity over the past several years. Private equity firms can utilize continuation funds to continue managing a company beyond the point at which they would normally exit by buying out existing LPs, who normally have the option of rolling their investments into the new vehicle or taking the liquidity option. In most cases, the 'majority of cash' is provided by secondary funds, and other investors interested in that new investment opportunity.

 

Last year, continuation funds accounted for more than half of the deal flow in secondaries[1]. As a relatively recent addition to the private equity scene, continuation funds have rapidly established themselves as an attractive part of the private market universe. 

 

Instead of selling companies outright or listing them on an exchange, private equity firms are using continuation funds to hold on to them for a longer period of time. It is likely that assets transferred to continuation funds are likely the best performers of the main fund, thus making them a growth play.

 

It is important to note that, the risk profile of continuation funds (or GP-led secondaries) differs significantly from traditional secondaries, in which a new investor would acquire an interest of another investor’s existing commitment in a primary fund (LP-led secondaries). Typically, LP-led secondaries or acquisitions of portfolios of primary funds held by other investors are more diversified and –as a consequence– have a different (more front-end loaded) cash-flow profile (compared to the more concentrated and often single asset GP-led transactions).  Additionally, given the higher diversification, the more imminently expected cash-flows, and the -at times- the tail-end character of some of those LP-led transactions, the equity multiples of LP-led secondaries are expected to be lower than with GP-led transactions, although internal rate of return (IRRs) are similar. On the other hand, continuation funds also have a different risk profile than primary funds given the higher concentration and the shorter term (usually 4-6 years) compared to a primary (8-12 years).Investors therefore need to take a view on whether they want to roll or make new investments into continuation funds that have a very different risk profile to primary funds and also LP-led secondaries.

 

It is likely that the tremendous growth of continuation funds is related to the issues private equity firms face when they attempt to remain invested in good performers while simultaneously exiting their original investments. Investors have always been concerned about the sale of a company from an older fund to a newer fund of the same private equity firm. Questions have been raised concerning valuation and timing. In most cases, conflict questions can be alleviated by having a third party set the price and terms of the continuation vehicle.

 

Continuation funds offer several potential advantages over other private equity investments

 

Investors may find continuation funds to be an attractive option; the portfolio company is generally selected based on its strong operating history, the private equity firm is usually strongly aligned with both old and new capital, and the holding period is typically four or five years. Continuation funds offer several potential advantages over other private equity investment vehicles. These advantages include:

 

Fees: Fees are usually lower for continuation funds compared to primary buyout funds, and since the majority of the capital is immediately deployed, fees on committed but uncalled capital are reduced meaningfully for new investors as compared to a new primary fund investment.

 

J-curve mitigation: With the elimination of fees on uncalled capital and the fact that the portfolio companies are already in the midst of their growth trajectory, private equity portfolios may have a zero J-curve for the portion invested in continuation funds.

 

Alignment: Alignment of interests via the GP contribution tends to be better than in the fund from which the company originated. This typically occurs because the GP is rolling over into the new vehicle the carried interest it is due. 

 

Capital deployment ramp-up: Investors can shorten the capital deployment ramp-up period from six or seven years to three or four years. As the ramp-up period is likely to approximately match the expected holding periods, building a continuation fund portfolio over four years makes sense. Starting with year five, realisations could be offset with portfolio additions to maintain the desired allocation.

 

Performance: When LPs consider all of the above elements, it seems likely that such a portfolio could deliver better performance compared to a highly diversified buyout portfolio built the old-fashioned way. There are no guarantees, of course, but the prospects are compelling.

 

It's not all sunshine and roses with continuation funds

 

The following are some considerations for investors: 

 

Due diligence: Despite the attractive characteristics, it is still imperative that comprehensive due diligence be conducted on private equity firms as the quality of the sponsor of such deals is a significant factor of success. In order to differentiate between private equity firms, investors should employ a process similar to the research they would conduct on primary commitments, although existing LPs have deep knowledge of the manager and likely the company. Further, the due diligence of continuation funds very much resembles the work of co-investments and standard secondary transaction reviews. It requires thorough business understanding and a deep corporate finance skillset and data availability to pursue such due diligence. Therefore, one needs to have access to sufficient and high-quality resources, data management tools, and standardized processes to be effective and successful in our opinion.

 

Access: In order to access continuation fund opportunities, investors need to form close links with intermediaries that structure these vehicles on behalf of the private equity firms. The number of such intermediaries is steadily growing and apart from well-known banks, smaller secondary intermediaries and placement agents are also active in this market. Additionally, having a broad and deep network across private equity firms (via commitments in their primary funds) helps to be informed about plans of creating continuation funds and securing access, accordingly. 

 

Concentration: Portfolio concentration cuts both ways. Compared to a typical portfolio built on primary funds, a continuation fund portfolio has far higher concentration. A concentrated portfolio has greater volatility, whereas a primary but a large primary buyout portfolio may be over-diversified. It is necessary to optimize the number of holdings, the quality of what is currently on the market, and the amount of resources to keep up with deal flow.

 

Success rate: In a typical private equity fund, gains and losses are netted before calculating carried interest. In single-asset Special Purpose Vehicles (SPVs), carried interest is now calculated at the single-asset level. If every transaction returned more than a typical 8% preferred return, it would not matter. However, an LP needs a success rate higher than a typical primary fund to keep incentive compensation from materially exceeding that of a normal PE portfolio. As many of the current crop of continuation funds have graduated carried interest structures, where the level of carry starts at 10% or 15% but may reach 25% or even 30% at a high net return multiple. The more volatile one’s portfolio is on a deal-by-deal basis, the higher the aggregate net carried interest percentage paid will likely be. As such, it merits consideration.

 

Strategy bias: Investors are primarily exposed to buyout funds from a strategic perspective. However, the use of a continuation strategy does not eliminate the need for a primary portfolio that includes venture capital and other strategies that would be underrepresented if the client concentrated exclusively on continuation funds.

 

Scale: As a final consideration, it is important to consider scale and how it impacts strategy. The higher concentration of continuation fund implies that a larger amount of capital necessitating more transactions is required to get sufficient diversification. On the other hand, with too small of an allocation, transaction and monitoring costs may become burdensome.

 

Continuation funds are a positive development for the private equity industry

 

We believe the introduction of continuation funds is a positive development for the private equity industry given their ability to provide earlier liquidity, lower fees, shorter capital deployment periods, and greater control over sector exposure. As a result, the continuation funds’ attractive structure allows investors to tailor their portfolios and extend their exposure to the turbo-charged end of the investment J-curve.

 

We argue that investors should seriously consider any opportunity they have to participate in this rapidly developing method of building private equity exposure and add an allocation to it in their overall private equity portfolio.

 

Conclusion

 

If the thesis that companies with strong operating momentum are potentially more attractive than the overall private equity universe is valid, then continuation vehicles offer a means to access such companies. Furthermore, this relatively recent innovation potentially allows investors to avoid the J-curve while also paying lower fees and having greater control over capital deployment and sector exposure. We argue that investors should seriously consider any opportunity they have to participate in this rapidly developing method of building private equity exposure.

 

1 Source: Jefferies, Global Secondary Market Review, January 2022

 



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