Private equity firms, in part because of how their funds are structured, tend to be temporary investors. They buy companies, execute a strategy aimed at maximizing their value and exit, hopefully at a valuation greater than they paid going in. Limited partners go along for the ride in the hope of reaping the benefits.
But for many funds, the interest rate landscape and other market conditions are drastically different now than when they were launched, leading to the rise in popularity of continuation funds or vehicles (CVs). In these deals, rather than sell the company to another investor or go public as a fund reaches its target exit date, the original sponsors opt to hold onto their investment, rolling it into a new fund with a timeline of another five to seven years. At that point, LPs in the original deal are typically given the choice to cash out or roll over into the new fund.
For the majority of individual investors, cashing out from the original fund continues to be the preferred option in a market with liquidity challenges. But those who can afford to keep their money tied up for another few years and feel the assets going into the continuation fund have room for significant further growth find it an attractive proposition.
The strategy has the potential to offer continuation fund participants alpha returns with a narrow focus on a few prime holdings, while avoiding a forced disposition of assets in what might be an unfavorable environment. For primary fund LPs, it also serves as another mechanism to access liquidity. Given current market conditions, continuation funds have become an increasingly popular strategy among both GPs and a select set of high-net-worth investors, according to industry observers.
Continuation funds “used to be an ‘Island of Misfit Toys’ for underperforming assets, but now they can contain prized private opportunities,” noted Nicholas Brown, managing partner with Granite Harbor Advisors, a Houston-based independent registered advisory firm, in a written response. “This supports our idea that more companies are looking to stay private longer and will wait to access the public markets as an exit opportunity for early investors rather than as a primary means of raising capital. That at least warrants a closer look at continuation funds when the opportunity arises.”
Similarly, Nick Zamparelli, senior vice president and chief investment officer with investment advisory firm Sequoia Financial Group, wrote that in the past, sponsors had been known to use continuation funds to hold onto problematic or distressed assets they could not sell. Since the funds are now being used to allow sponsors to hold well-performing assets until a better-timed exit and give existing LPs an opportunity to access liquidity they can be attractive, he noted.
“We think the structure of continuation funds, used responsibly, can benefit both the fund and the investors by allowing the fund to take later exits and the investor to receive liquidity earlier.”
As these comments show, CVs are not a new vehicle, having been around for more than a decade. But their use has spiked in the past five years as players in the secondaries market have gotten more comfortable with the strategy and as M&As and IPOs became more difficult to execute with the Federal Reserve rapidly raising interest rates.
With private equity investments increasingly becoming available to accredited investors through limited liquidity vehicles and feeder funds, financial advisors will likely be evaluating more opportunities to roll over their clients’ money from primary funds into CVs or to have them come in as new investors in continuation funds. It’s another factor to consider in assessing the private equity market. And it creates increased competition for secondaries, an already hot segment of the private equity market that many newer funds are targeting in order to create vintage diversification.
Last year, private equity investment exits in the U.S. totaled $227.2 billion, or just 7.6% of the roughly $3 trillion in assets under management that private equity firms held at the beginning of 2023, according to the 2024 U.S. Private Equity Outlook from capital markets data provider PitchBook. That level was lower than the one recorded during the depth of the Great Financial Crisis in 2009. In an environment of rising interest rates, high inflation and general uncertainty about the course of the U.S. economy, private equity’s traditional exit strategies, including M&As and IPOs, have become a challenge.
With many investors pausing on new commitments, it has also been more challenging to raise capital for primary funds, noted Jeff Hammer, global co-head of secondaries with Manulife Investment Management, a global wealth and asset management segment of Manulife Financial Corp. That process currently takes on average 18 months, while a continuation fund can be put together in the space of three to six months, he said.
This has paved the way for continuation funds to become an attractive exit option. Through December 5 in 2023, PitchBook tracked 71 exits into continuation funds, totaling $6.1 billion—a figure roughly commensurate with 2022, but far above 42 exits totaling $3.5 billion in 2021. It also marked a steady climb from 2017, when PitchBook started tracking the sector. In 2024, the firm expects potentially more than 100 such transactions.
In November, for example, private equity firm GenNx360 created a continuation fund in order to continue holding Precision Aviation Group (PAC), a provider of products and services to the aerospace and defense industries globally. GenNx360 initially acquired the company in 2018. It claims to have increased its EBITDA since then by about 400%. But the private equity firm believes there are more opportunities for growth and new acquisitions that can take PAC’s value further.
Earlier in 2023, Goldman Sachs Asset Management, with co-leads Blackstone Strategic Partners, Portfolio Advisors and TPG, moved U.S. healthcare laundry services provider ImageFIRST into a continuation vehicle valued at more than $700 million, reported Secondaries Investor. The fund ended up oversubscribed, according to the publication, which also reported that the majority of LPs in the primary vehicle, Calera Capital Partners V, planned to cash out of the transaction.
Continuation funds currently make up about 80% of the GP-led secondaries market worldwide, said Amanda Ugarte, head of U.S. secondary advisory with financial advisory and asset management firm Lazard. Their number and dollar volume has been on the rise since 2017, when the secondaries market started to feel comfortable with transactions that involved one or just a handful of companies vs. a much more diversified set of holdings. In fact, some investors who have not been traditional players in secondaries started to access the market specifically for single-asset continuation funds, Ugarte noted.
“Capital continues to form to invest in continuation fund vehicles and there is a significant supply of potential assets to move into such vehicles, so we expect that this part of the secondary market will continue to grow,” Ugarte said.
Executives with investment advisor Upwelling Capital Group LLC agree that continuation funds are here to stay. They offer a way for primary fund LPs to cash out at fair values, while investors in the continuation fund can potentially achieve attractive returns with very targeted exposures, according to a fall 2023 note from the firm.
Upwelling points to the fact that capital going into secondary funds, which include continuation funds, has increased considerably in recent years as evidence that LPs have a solid appetite for them. In 2021 and 2022, for instance, such funds raised more than $100 billion, compared to annual totals of anywhere from $25 billion to $80 billion in the preceding decade, according to data from Evercore.
Sponsors also tend to prefer continuation funds over some other types of secondary vehicles because they can be easier to assemble, noted Hammer. “Sponsors are driven to achieve investment and fundraising success. In launching a continuation fund, sponsors are able to accomplish both objectives. A CV is a partnership that is capitalized quickly, but managed for years,” he said. “It’s a great outcome for sponsors!”
Even if the Federal Reserve ends up lowering interest rates later this year and the market for traditional private equity investment exits opens up, it’s not likely to dampen interest in continuation funds, according to Ugarte. Continuation funds that make the most sense involve situations where the sponsors either would like to hold onto a trophy asset for longer, think they can create value with more time and/or need additional capital to realize their objectives, she noted. None of those needs will go away with lower interest rates. As proof, she pointed to 2021 when fundraising for these vehicles reached a high watermark even though both the regular-way M&A and IPO markets were active.
“Industry needs to innovate, find new liquidity using a different structure and we think this is the most obvious third option that will be tapped more frequently going forward,” said Tim Clarke, manager and lead analyst, private equity, with PitchBook. “It’s not new by any means, secondary markets have been around for a while. But we think that for a variety of factors it hits critical mass this year.”
Why LPs tend to cash out
However, as has reportedly been the case with the continuation vehicle holding ImageFIRST, more than 80% of existing LPs tend to cash out of such transactions, Ugarte noted. Hammer estimates that since interest rates started rising in 2022, the current figure might be even higher, around 90% or 95%. The majority of capital going into the continuation funds comes from dedicated secondary funds, supplemented by traditional LPs, family offices and sovereign wealth funds, according to Ugarte.
“LPs take cash in CV transactions because they get much-needed liquidity that is not available elsewhere,” said Hammer. “CVs are, in effect, a ‘pressure release valve’ for the private equity market. The main constraint on CV execution today is capital. There is simply insufficient capital for even the majority of CVs that sponsors are bringing to market. It is a great time to be an investor in this market.”
In addition to needing liquidity, LPs might be opting to cash out because they feel they are already getting attractive returns. Especially when it comes to exits into continuation vehicles holding a single asset, a second quarter report from Lazard found that 58% of such deals priced at or above NAV, offering an incentive to take the money available now instead of waiting for a future payout. (Since the terms of every deal differ, in some cases LPs might also need to take a discount of as much as 10% to cash out, noted Clarke).
Many LPs forego continuation funds because the decision window they get to evaluate their options is often so short—20 or 30 days—that they don’t feel confident they’ll be able to complete the necessary due diligence to understand the asset they are investing in, according to Hammer. If they feel they are getting an attractive payout to leave the fund, they will opt for that rather than rolling over into a vehicle they don’t have the capacity to evaluate properly.
Why continuation funds might be attractive
For those advisors and investors who decide to roll over money or come in as new partners on a continuation fund, these vehicles can bring alpha returns and offer them a chance for a targeted investment strategy, according to Hammer. With money committed to a primary fund, LPs are buying into a strategy rather than specific assets, he noted. Continuation funds, on the other hand, offer an opportunity to invest in one or more known assets with high growth prospects.
“In constructing CV portfolios, you are not using a woodman’s axe—you are using a surgeon’s scalpel,” he noted. “You can say ‘I want to be in healthcare sector. I want to be in a medical device company.’ You are able to get very prescriptive about portfolio construction. Stepping back, if you compare the traditional LP secondary (beta) strategy with the GP-led (alpha) strategy, you end up with very different portfolios.”
Continuation fund investors are counting for, on average, returns of 2x to 2.5x on the go-forward basis for single assets included in these vehicles, according to Ugarte. Existing LPs who are opting for liquidity should expect returns of at least 2x. While continuation fund terms tend to be bespoke for every deal, they must be a win for both new and existing investors, she said.
An example of a successful continuation fund is one that TPG put together for Creative Artists Agency, a talent agency TPG has held a stake in through various vehicles since 2010, noted Clarke. At the time the continuation fund transaction closed in 2021, Creative Artists was valued at $3 billion. By the time TPG sold it to French family office Artemis last November, the company’s enterprise value reached approximately $7 billion, helped by the return of live events in the post-Covid era, new content creation and the purchase of sports rights. Investors in TPG’s continuation fund made 2x multiple of their invested capital, with an IRR above 30%, according to Secondaries Investor.
“Individual investors have come into our deals through the private wealth channel,” said Hammer. (Manulife invests in continuation funds on behalf of its general account and third-parties through a commingled fund.) “Individual investors become aware of strong private companies through the press, public announcements, etc. Often, they would like to participate in the ownership of these growing, dynamic private companies. Continuation funds enable them to get this exposure.”
Issues to be aware of
While continuation funds can be an attractive investment option, they vary in quality and can come with a host of issues, ranging from GPs’ conflicts of interest to overly optimistic growth projections to high carry fees. Hammer noted that Manulife Investment Management looks at about four continuation funds a week, with last year’s total reaching 197 such deals.
However, “we invest in a tiny fraction of the deals we review—not by a long shot is everything offered investment-worthy,” he said.
While there have not been high-profile cases of continuation funds ending up with a loss, he has heard through the industry grapevine that some vehicles have not achieved the growth trajectory they were counting on. That may have been because the public market valuations declined, bringing with them private sector valuations, or because the companies held in the fund were overleveraged, for instance.
An important decision factor for whether Manulife opts to invest in a continuation fund is whether the GPs are rolling over their own stakes into the vehicle and whether they are investing in the transaction at the same value as the LPs. “We look very carefully for alignment,” Hammer said. “If the sponsor is net leaving, we are not interested.”
In fact, individual investors and their advisors should make sure that an independent third party has assessed that the fair market value of the assets being rolled over is accurate, according to both Clarke and Ugarte. If you get a third-party assessment and their value opinion is not aligned with the fund sponsors’ or they can’t come up with a number, that’s a bad sign, Clarke said. In fact, new SEC rules have gone into effect in November that dictate advisors must get a third-party valuation for continuation fund transactions to ensure transparency.
“As long as the GP can properly align the incentives for a continuation fund, it can be an effective structure,” noted Zamparelli. “Given that the manager sits on both the sell and buy sides, continuation funds have been controversial due to perceived conflicts of interest. We do think it allows for some gaming, so these funds really have to be looked at carefully.”
Financial advisors also need to remember that the primary reason for investing in a private equity vehicle vs. another investment option is value appreciation since the investors won’t be getting regular dividends or cash flow, said Clarke. As a result, continuation funds make sense for trophy assets that can benefit from a longer hold to give them time to grow their earnings and make new acquisitions. When it comes to lesser quality companies, a continuation fund may not offer much upside to the LPs.
Upwelling Capital offers several tips to help separate attractive continuation fund opportunities from questionable ones. The firm advises investors to assess whether the assets in the fund have growth potential outside of a traditional private equity exit strategy. These would include organic CAPEX or acquisition opportunities. It suggests sticking with deals that offer LPs at least 30 days to decide whether to roll over their funds. There should also be a clearly defined rationale for creating a continuation vehicle and extending the hold time by five to seven years, such as assets will realize greater market value with more time or the GP wants to become a majority shareholder, Upwelling noted.