Once thought of as vehicles formed to restructure underperforming assets, continuation funds are now utilized as management vehicles for long-held trophy assets. Today, these funds are raised by general partners (GP) to buy one or more of their best portfolio companies out of existing funds as they reach the end of their lives, in order to extract additional value from those assets. Capital for these vehicles is generally raised through a combination of co-investment and/or other private funds, limited partner (LP) or GP equity rolled from the legacy fund investment, as well as new LP capital, and is used to purchase the assets from the legacy fund(s) and to fund growth initiatives.
The growth in continuation funds, illustrated in this week’s chart, isn’t surprising when you consider that they check several boxes for both GPs and LPs. Most importantly, they help GPs fulfill their obligation to exit portfolio companies after a set period of ownership, offering liquidity to LPs who want it.
Exiting legacy portfolio investments also benefits GPs by making it easier to raise new funds, since prospective investors generally attribute more weight to a GP’s realized track record than its unrealized one. The funds also enable GPs to reset their fee clocks — allowing them to continue to charge management fees and ultimately carried interest on known, high-growth-potential companies.
For LPs, having the flexibility to receive and retain a capital distribution, roll either all or a portion of currently invested capital or invest additional capital into a new fund with known, de-risked assets allows them to optimize their cash flow and capital deployment models on the fly. The shorter time frame for these investments — often three or four years compared to a typical fund’s holding period, which usually exceeds 10 years — is also attractive as the capital will be returned to LPs more quickly.
This gives them the ability to redeploy the proceeds much more quickly than would otherwise be possible. Additionally, continuation fund fees are generally a bit lower than those of a traditional private equity (PE) fund, and preferences are likely to be more skewed in the LP’s favor.
While continuation funds have been around for several years, there has been a marked increase in their recent use by GPs, as they now serve as a bonafide exit option alongside sale to a strategic or financial buyer, sale to a special purpose acquisition company (SPAC) or an initial public offering (IPO). Here are some examples of recent transactions:
- BC Partners closed a single-asset continuation fund in June 2021 to purchase academic publisher Springer Nature from BC European Cap Fund IX, a 2011 vintage fund. The deal was led by Neuberger Berman.
- In January 2021, Audax Private Equity closed a $1.7 billion continuation fund, jointly led by AlpInvest Partners, Lexington Partners and Hamilton Lane, to purchase Innovative Chemical Products Group, Justrite Safety Group, 42 North Dental and TPC Wire & Cable Corp from Audax Private Equity Fund IV, a 2012 vintage fund.
- In November 2020, Ampersand Capital closed a $670 million continuation fund, led by StepStone Group, to purchase three portfolio companies, including Confluent Medical Technologies, from multiple mature Ampersand funds.
In addition to the transactions highlighted above, groups such as Blackstone, KKR and Hellman & Friedman have each recently sold existing portfolio companies to their respective continuation funds.
Continuation funds are not without their challenges. Traditionally, LPs hire GPs to make all asset buy/hold/sell decisions. With continuation funds, the onus shifts to the LP — requiring specific asset-level due diligence that is typically not required for traditional fund investors. Because the GP is both the seller and buyer in the transaction, there is an inherent conflict regarding how the transaction price is determined.
A range of strategies have been adopted by GPs to mitigate concerns over conflicts of interest, including the establishment of independent expert panels to determine a fair valuation, third-party fairness opinions issued by dedicated valuation groups, running competitive auction processes and Limited Partner Advisory Committee sign-off — so LPs will need to determine their own comfort level with the transaction value.
Planning or budgeting for a continuation fund is difficult, as GPs often do not communicate their intention to raise one until the process is already underway. Finally, the amount of time that LPs have to determine the action they will take when their assets are pledged to a continuation fund transaction is often brief, sometimes as short as one week, making it difficult to make a well-informed decision.
Continuation funds keep growing in popularity as GPs look for new ways to offer their investors liquidity. The increased use offers LPs an opportunity to choose between taking liquidity or rolling their capital into known, de-risked assets that have the potential to outperform less-seasoned assets. While these funds hold the potential to deliver strong returns, they don’t come without some challenges. LPs should be aware of those challenges and how to address them because if history is any indication, these transactions will be coming faster and more furious as fund portfolios continue to mature.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
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