By Matteo Ravera
It goes without saying that the goal of a Private Equity firm is to sell an asset it previously invested in, make a very high IRR and eventually collect its carried interest. But what happens if PE firms sell that asset to themselves?
It can sound strange but that’s exactly the case for Continuation Funds, a peculiar type of Secondary Private Equity deals that recently became very popular.
Introduction to the theory behind continuation funds
A continuation fund is an investment vehicle created by a PE firm with the purpose of acquiring an asset, or a portfolio of assets, that are currently held by another fund which is managed by the same sponsor. The General Partners are of course committed to their investors to get them their money back along with a profit, in a span of 10 years. Still, due to various reasons such as adverse market conditions or the expectation that they will be able to generate greater returns by holding the assets for longer, GPs may not consider an exit as the most efficient move. In cases like these, setting up a continuation fund can be pretty useful for the GPs as they can liquidate the investors who want to cash out, freeze the IRR of the legacy fund, get paid the carried interest for their performance and keep a high potential asset in their portfolio.
Let’s make a very simple example to understand how these deals are actually structured. Let’s assume the PE, through fund 1, has invested only in company A with a time horizon of 5 years. At the end of that period the PE will need to exit company A and liquidate the LPs of fund 1. If, for some reason (we’ll get to those later), the GPs want to hold on to the asset for longer they can transfer it to fund 2. At the time of sale, LPs from fund 1 may have the option to choose between getting their money back or to roll over to fund 2. Fund 1 gets closed and the LPs who did not choose to keep their money invested with the asset will get their capital plus the realized return. The GPs are then able to freeze the IRR of fund 1 and collect the carried interest while keeping company A in the portfolio of fund 2.
The following is a step-by-step “text-book” process of how a Continuation Fund works outlined by the Financial Times:
Original private equity fund: company or companies carved out. At this first stage, the PE firm has to select the company/companies that will be sold to the continuation vehicle and separate them from the original fund.
Advisers call secondary funds, present the valuation of the company to be placed in the Continuation Fund, and ask for bids
Secondary funds say how much they would commit to the new vehicle and at what valuation. They can also include terms on management fees and carried interest. Typically, if a deal needs $1bn of equity, two or three large funds would commit about $200m each. Then the process can move to stage four, when the rest of the equity will be raised.
Once a couple of large players have signed up, the book building process begins – advisers raise the rest of the money from smaller investors on the terms agreed by the bigger groups. In the $1bn example above, they may commit about $25m each
Investors in the original fund can buy into the new vehicle or cash out. The private equity firm is expected to keep some of its own money in the new fund too
The company is transferred to the new fund
Focus on attractive features
In a very interesting and informal interview with “Il Pub del Lunedì Sera”, Gabriele Questa, a MD at KKR outlined a few aspects that are worth focusing on.
When starting a new fund, the process of scouting the market for the right target can take very long, cost a lot of money and nothing guarantees that the company you will be able to invest in will be better than the one you are already holding in your portfolio. If the fund is invested in a very good asset, with a big still unrealized upside potential and the GPs do not expect to find a target that has much more potential a continuation fund can be a very good option. Also, “going for another round” with that asset can make the life of the GPs much easier, e.g. they know the company and the industry very well, they trust the management and have already significantly increased the company’s operational efficiency. By keeping the company the new fund can basically skip the scouting process and needs to do significantly less in the due diligence process, which can save a lot of money. Second, given the work the sponsor has probably done with the asset, the portfolio company can now spend more money and pursue ambitious growth strategies i.e. through larger acquisitions. In a fraction of the time, it will take in normal deals, with a continuation fund the sponsor can both provide a profitable exit to current investors and keep a very promising asset into the new fund.
Win-win? Not exactly.
A fairly big portion of this kind of GP-led secondary deals that were initiated, never got to closing. The reason for that could be the various conflicts of interest. On such transactions, GPs are representing both sides of the deal and that makes everything more difficult.
Issues and conflicts
The first and largest issue is the valuation at which the deal can be closed. The GPs have the obligation to maximize returns for both existing investors and those who put money into the continuation fund. If the price is high, the LPs of the legacy fund who choose to sell will be very happy, but that kind of valuation will probably eat out a portion of the expected return of the new investors. It can still be convenient for the GPs who will cash a bigger carried interest, but new investors might not commit their money at that price. If the price is set too low, current investors will get lower returns in favor of future profit for the continuation fund LPs. As money managers GPs cannot really afford that. Furthermore, it is important to highlight that even if the sponsors have an actual conflict of interest, they will probably try to avoid taking an opportunistic advantage from it. The reputational damage in this industry, where trust is everything, would be enormous. There has to be an equilibrium based on the fundamentals of the company that can make everyone happy. It should not be an unsolvable problem.
First, the GPs should be very careful in the choice of which assets to hold, in fact picking those companies that have very strong business fundamentals will make it easier to raise money for the continuation vehicle. Second, the valuation process has to be conducted fairly and with a great transparency in favor of both the old and new investors.Third, the sponsor should ask for a fairness opinion to reduce the risk of a conflict of interest. Last but not least, GPs should have “skin in the game”. If they are the first ones to put money in the deal, other investors will be more confident that the investment is actually a great opportunity.
The sponsor commitment is a key aspect of continuation fund transactions which feature a term structure that is a bit different from traditional PE funds. Other differences can be found in the fee structure. For example, the waterfalls can be more complex, with different carried interest rates and hurdle rates, while investors from the legacy fund who rolled on to the new vehicle may be offered the option to maintain the same contractual terms as before. Furthermore, the continuation fund can include undrawn commitments for extra investments in the company, i.e. an acquisition. The new investors, or buyers, may require that a minimum invested amount held by existing investors has to be sold to make the deal worthwhile (c.d. floor). Also, the deal can set a maximum amount of capital that new investors can commit, therefore requiring a minimum number of old investors who roll into the continuation fund.
Adding up these issues can make the governance of these funds very complex but at the same time still be very attractive for the GPs.
The COVID effect
The COVID crisis has radically changed the way we live and is likely to impact the way we will live in the future. What is certain, is that it started, or at least accelerated, many trends in many different industries. In PE one trend was the rise of Continuation Funds. Not being a new model, it saw a big increase in deal volume in 2020. Even if many of the continuation fund deals were planned long before, the pandemic outbreak created a set of circumstances that made it much easier for them to become popular.
First, the M&A market slowdown has made the life of GPs much more difficult. Corporate executives were less likely to make important investment decisions such as new acquisitions. This made exiting through a trade sale an unlikely option. Moreover, if GPs could manage to find a bu yer, it could be harder to get the valuation they expected.
Second, fund managers were in need for liquidity to fulfil the promise to their investors. Many funds were reaching the end of their lifespan and needed to be exited. Another profitable idea could be to take a portfolio company public, but again there were adverse conditions in the markets and the process is longer and harder as not all companies are a suitable candidate for an IPO. Furthermore, there was a large excess of dry powder waiting to be deployed, especially after many sponsors had just raised record amounts of funding for secondary funds.
Conclusions and outlook
Continuation funds proved to be a very useful and attractive tool for Private Equity firms but along with popularity they also raised scrutiny. Their use should be limited to special situations. Examples include when a company needs further work before being sold, when there is a strong belief that holding the asset for longer can create much more value, and to protect investors’ returns in case the current market cannot reflect the right price for the company. If used with care, continuation funds can provide a win-win-win solution for GPs, current LPs and new buyers. Anyway, continuation funds should not be treated as put options for the sale of an asset and consequently tilt the attitude of PE firms towards risk. The tensions between the actors, the various options to mitigate the risk of conflicts of interest and the great importance of trust should act as a safeguard against opportunistic behaviour of any party involved.
Most relevant recent deals
Blackstone: BioMed Realty Trust, $14.6bn
EQT: Industrial & Financial Systems, $3bn
Clearlake Capital: Fastest ever GP-led secondary, Ivanti
BC Partners: (planning)Springer Natures, $6bn
Hellman and Friedman: Verisure and other portfolio companies, $17bn
Author: Matteo Ravera
Editor: Boris Mihaylov