Why PE and VC Firms Want to Hold: Continuation Funds

Introduction

Under a historically challenging macro environment with investors facing significant headwinds across asset classes, one sub-segment in private equity has nevertheless succeeded in 2021: the secondary market, with continuation funds as their primary vehicles of return. Across this article, we will examine the purpose and underlying elements of continuation funds, derive a critical comparison between the promise—and risk—that these funds hold, and study two cases of recently emerging continuation funds: Clayton, Dubilier & Rice’s 2021 continuation deal with Belron, and HV Capital’s founding of the COCO Growth Fund.

How Does a Continuation Fund Work?

A continuation fund, also known as a GP-led secondary, is a tool that allows a private equity firm to hold a portfolio company for a longer duration than the traditional 10-year fund lifecycle.

Simply put, a special purpose vehicle (SPV) company is created by the GP/fund manager; by acquiring a new set of LPs and using the liquidity from the original LPs who rolled over their interest to the new SPV, the SPV is able to purchase one, a few, or a part of (strip) several trophy assets, all of which will be brought into a new fund—the continuation fund.

In the past, it was seen as a way to restructure underperforming assets, while in the last few years, the focus of these funds has turned towards trophy assets. This term, used in real estate to describe a property that is in exceptionally high demand by investors, is used in this case to refer to particularly well-performing companies. Therefore, the longer period of holding allowed by the continuation fund can be considered a momentum or growth play. Investors in the existing fund may be offered the option either to sell or to roll their holdings into the new continuation vehicle, with or without additional capital.

New investors will make a cash contribution to the continuation fund, providing liquidity for investors in the existing fund who have decided to sell. The specific terms of a continuation fund are the results of the negotiation between the sponsor and the new investors and they are influenced by asset-specific nuances.

Most recently, in 2021, GP-led secondary deal volume hit $63 billion dollars globally, representing more than a double increase from the $30 billion in 2020, according to Lazard’s Sponsor-Led Secondary Market Report.

Reasons Behind Their Success

Continuation funds were once a niche strategy but now they are gaining popularity because of the benefits they are able to offer to both GPs and LPs.

GPs can continue to charge management fees and ultimately carried interest on known, high-growth-potential companies while fulfilling their obligation to exit portfolio companies after a set period of ownership. LPs increase the options available to them: if they believe they can secure further economic gains, they will invest; if not, they are free to seek liquidity instead. Moreover, a continuation fund generally has a shorter liquidity timeframe than the original fund, often three or four years.

While the number of secondary funds that closed in 2020 was down from the previous year—29 compared with 44 in 2019—a record $96.6 billion in new secondary funds was amassed. It is clear, too, that with an increasingly volatile market, continuation vehicles are set to increase in size and number, as exits through an IPO or the M&A market bring uncertainty.

The Promise and Risk of Continuation Funds

The success of private equity funds has been historically built on the alignment of objectives between investors and managers, but the incentive model that allowed this is at risk in the case of continuation vehicles.

The complex nature of GP-led secondary transactions like continuation funds, in which the sponsor is effectively on both sides of the deal, gives rise to disagreement on value and concerns about the rationale of the deal. It is easy to see that this situation creates a potential conflict of interest with regard to the transaction price.

On one hand, to generate an attractive liquidity option, the sponsor must offer a convincing business case and price to potential buyers. On the other hand, the sponsor, being the manager of the old fund, also has a duty as a seller.

The price needs to be set at a level that makes the investors who want to cash out feel they’re getting value and, at the same time, it shouldn’t be so high that new investors don’t want to come in. GPs have adopted different strategies to address this problem and reduce concerns over conflict of interests: organizing competitive auctions and using independent expert panels to determine a fair valuation are two of them. Another problem involved in continuation funds is the short decision-making time frame: sometimes LPs must choose which course of action to take in just one week. Investors pay managers to make this type of decision (buy, hold, sell), but with continuation funds the liability shifts from the general partner to them. According to Ms. Nazemi, co-head of funds and co-investments at investment-management firm Barings LLC, many of them opt to just sell: to make an informed decision it would be necessary to perform a specific asset-level due diligence that these investors are not used to.

The Largest Single-asset Continuation Deal: CD&R and Belron

In December 2021, Clayton, Dubilier & Rice (CD&R), a Private Equity firm headquartered in New YorK, engaged in a two-part transaction sale of its investment in Belron, a worldwide leader in vehicle glass repair and replacement. Approximately 39% of CD&R’s stake in Belron was sold to investors including Hellman & Friedman, GIC, and BlackRock Private Equity Partners. This deal valued Belron at €21 billion, a near-seven-fold increase from its original valuation of €3 (or approximately $3.4 billion today) in 2018 via CD&R Fund X.

Interestingly, the remaining 61% of the CD&R Fund X ownership position on Belron was sold to a new $4 billion CD&R-managed SPV called CD&R Value Building Partners I, L.P., which allowed CD&R to continue its partnership with Belron.

Expounding on Belron’s potential as a trophy asset under the PE firm’s eyes, Eric Rouzier, CD&R Partner, shared that with Belron’s steady growth over the past 20 years, CD&R believed Belron was “now regarded as one of the leading, best-in-class global services businesses, reflecting its global and local market presence, exceptional customer satisfaction, and strong financial performance.” This, coupled with structural growth tailwinds led by an “increase in miles driven” and improving “windshield technology and complexity,” likely shaped the investment thesis upon which the PE firm acted.

Under a single asset secondary market transaction like this one, an SPV is set up to acquire one asset—Belron—from an existing fund—CD&R Fund X. Transactions like these have made up one-quarter of the overall $48 billion secondary sales done during the first half of 2021, representing a 206% increase against the first half of 2020, according to data from Evercore Inc.

However, while, as with any continuation fund, single-asset deals give existing LPs from the older fund the choice to get liquidy (i.e., cash-out) or remain and roll or re-invest back into the continuation fund, in CD&R’s case, it was unclear if existing investors had the option to roll. Nevertheless, this largest-ever single-asset continuation deal sets an example for private equity firms around the world on the future—and direction—of PE in the secondary market.

HV Capital’s HV COCO Growth Fund: Germany’s First Continuation Fund Launched by a VC Firm

Most recently, in February 2022, HV Capital, a Berlin and Munich-based venture capital (VC) firm announced the launch of HV COCO Growth, the first VC-led continuation fund in Germany. This €430m fund will allow HV Capital to support its growth investments in portfolio companies, including FlixMobility, Global Savings Group, and SumUp from existing funds and offer an opportunity to expand further. Among the investors of the fund are global private equity fund of funds HarbourVest, alternative investment specialist LGT Capital Partners, private market fund-solutions provider Pathway Capital, and Holtzbrinck Publishing Group, a German publishing and media holding company.

David Kuczek, GP at HV Capital, shares that with the companies they “really believe in, [they] don’t want to be forced to sell them.” According to Kuczek, “the first eight years with startups are like wartime, it is very hard to gain a solid position on the market. But, if you can survive those eight years, you can be really successful.” This explains the growing interest by VC firms in continuation funds: it allows them to hold onto companies that offer the potential for greater value creation beyond the typical lifecycle.

HV Capital will transfer investment from their three funds from 2010 to 2015—HV IV, HV V, and HV Co-investment Fund—to HV COCO Growth, their new continuation fund, bringing a new financing model to the German VC market.

HV COCO Growth has the potential to solve a classic dilemma in start-up financing: the need for start-ups to IPO within the typical ten-year timeframe, even when many company values are often generated beyond these cycles. FlixMobility—a transportation company HV Capital invested in through its 2012 HV V fund—is the perfect example. Nearing the end of its term, FlixMobility should soon seek an IPO. However, structural headwinds from the pandemic in the transportation industry and the recent slump in technology equities have posed the prospects for a successful IPO in a darker light in the near future. Through HV COCO Growth, HV Capital is able to give FlixMobility more time to achieve its projected success.

Given the potential for growth and returns that continuation funds promise for firms in private equity and venture capital markets, it is self-evident why they may want to hold on.