Private equity continuation funds are generating more buzz than investments. At least so far.
With deals scarce, private equity firms are holding onto some of their most promising portfolio companies longer, rolling them into new funds.
But most asset owners are passing on these so-called continuation funds — even though they believe the investment opportunities are attractive.
Although the relatively new concept sounds simple, managers can’t lock up investors in the original fund beyond terms set in the contract. As an alternative, managers move a single asset, or a small group of assets, into a continuation fund. Investors can then either liquidate or roll over their stakes into the new structure; private equity firms can also add new investors or their own money to the vehicle.
In theory, this works for everyone. In practice, an estimated 90 percent of limited partners are liquidating their investments rather than rolling over into a new fund, according to Michael Forestner, global chief investment officer of private markets at Mercer. If managers are moving their so-called “crown jewels,” as Forestner puts it, into continuation vehicles, why are limited partners casting them aside?
“Just because LPs are accepting a liquidity route doesn’t mean they wanted to sell,” said Brian Hoehn, a senior associate at the Institutional Limited Partners’ Association. “It means they maybe don’t have the time or option to move forward with it.”
A chief complaint among LPs has been the tight time frame — sometimes between 10 and 20 days — to decide whether to cash out or transfer investments into a new fund. In some cases, they may be forced to liquidate — even if they want in on the new fund — because there isn’t enough time to get approval from their board. Governance rules vary at every asset owner, but some require board approval for investments or the underwriting process. If boards meet monthly, or even quarterly, there may not be enough time for an investment team to present an idea to their trustees.
The deals also eat up allocators’ time, particularly because the due diligence required to vet a portfolio company is far different than what’s needed to dig into a fund or a manager, according to Hoehn. The process is challenging for allocators that don’t have co-investment or other experience, as they aren’t regularly looking at single assets, according to Neal Prunier, Hoehn’s colleague and ILPA senior director of industry affairs.
Continuation funds also raise issues of alignment between the manager and investor. “What bothers me about continuation funds is the obvious conflicts of interest,” said Karl Scheer, chief investment officer at the University of Cincinnati, in an email. As he puts it, when an investment manager sets up a continuation fund, they’re valuing the asset themselves, earning carry — or performance fees — on that valuation. Then, they move the investment into a new fund, which will earn new fees. All of this is done with “minimal” objective oversight, he said.
Some LPs believe that the goal of a continuation fund should be simply to own an asset beyond the life of the fund. In their view, it’s an inappropriate use of the structure if the original fund will continue to exist after the company is removed.
“It’s maybe one thing if it’s the twelfth year of a fund but it is just downright inexcusable if the fund has owned the asset for under five years,” Scheer said.
Other concerns for allocators include a private equity firm providing little capital of its own for the continuation vehicle or bringing in a secondary fund to price the transaction, according to Forestner. “Having secondary funds as lead pricing parties on these transactions, and I don’t care how many fairness opinions you get, it’s not as good as a new GP [general partner] coming in at that same price point.”
Some asset owners are frustrated by learning of continuation fund vehicles in the secondary market, rather than hearing it from the managers themselves.
“There are so many places where these can rub investors the wrong way,” Forestner said. “It can be fraught with peril for a GP to decide to do one, depending on what their LPs want and whether they view these transactions favorably.”
But there are circumstances in which continuation funds make sense. According to Forestner, they work best when a company appears primed for a merger, acquisition, or roll-up. A complicated deal process can be run more efficiently in a new fund.
In an ideal situation, according to Forestner, a general partner rolls all — or most — of their crystalized carry into a new vehicle. That means the managers is transferring the carry, or performance fees they’ve earned, into the new fund. This, coupled with early notice, transparency into the process, a price set by a “good quality” GP, and relatively low fees would make for an attractive deal, he added.
There are other scenarios in which GPs may be better off doing a follow-on investment from a fund or a co-investment of capital instead of a continuation vehicle.
“The best thing the GP can do is socialize the idea behind the transaction,” Hoehn added.
For private equity firms that believe a continuation vehicle is their best path forward, there is hope. Some investors have started changing their governance processes to accommodate continuation vehicles, according to Hoehn.
And ILPA has started taking up the issue as part of its advocacy. Last year, ILPA released an updated due diligence questionnaire — a standard document used by investors to make the process run more smoothly — with an added section covering continuation funds and GP-led secondaries. The questions include whether Limited Partner Advisory Committees reviewed conflicts of interest in past continuation funds and how private equity firms structure continuation fund documents. ILPA is also planning to address the funds in future guidance.
“What LPs are looking for is information ahead of and during a transaction, business rationale, and then alignment of interests between the GP and the new vehicle that’s being created,” Hoehn said.