The article below is from our BRIEFINGS newsletter of 19 August 2021
The private equity industry is turning to continuation funds as a way to hold on to high-performing assets for longer. We sat down with Alexander Mejia, who leads the private equity sponsor secondary market advisory within the Investment Banking Division to discuss the growing popularity of these vehicles.
Alexander, what are continuation funds and how do they work?
Alexander Mejia: Traditional private equity funds are typically set up with fixed 10-year terms; the sponsors’ goal is to acquire businesses, create value and ultimately sell the businesses within that period. But what we’re increasingly seeing is that more sponsors want to hold on to their investments for longer. In some cases, it’s because the investment is performing well—it’s a “trophy asset” within their portfolio and they don’t want to part ways with it. Alternatively, they want to give the business more time and money to develop, which the business may not have had, given the existing fund’s term and capital constraints. At the same time, limited partners (LPs) are increasingly focused on liquidity, especially with sponsors’ longer-dated assets, so there’s a duration mismatch between the sponsors who aren’t ready to sell those assets and the limited partners who want to monetize their investments. Continuation funds are a transaction structure that works to achieve two objectives: First, they allow private equity sponsors to provide their LPs a liquidity option—they can elect to cash out or roll into the new vehicle. Second, the funds extend the duration of their holdings and raise new capital to accelerate M&A or other growth initiatives at the underlying companies. At the end of the day, these transactions should provide a win-win outcome to all parties involved.
Tell us more about why some sponsors want to hold on to their investments for longer.
Alexander Mejia: In many cases, sponsors see additional room for their investments in certain companies to grow. They’ve spent years developing strong relationships with management teams and building high-quality businesses that they often sell prematurely to satisfy existing fund dynamics. Rather than sell outright, they would prefer to continue owning and growing the business. Sponsors further benefit from their ability to retain assets under management through these transactions. Lastly, given the increased competitiveness of the sponsor market, we’re seeing GPs invest alongside other investors in the continuation funds into their “trophy assets,” thereby finding unique ways to deploy new capital and increase their overall exposure to these assets.
How did the pandemic affect sponsors’ interest in continuation funds?
Alexander Mejia: The pandemic has been a big driver of volume, because many of the underlying portfolio companies fell behind in their growth plans and needed more time and capital to get back on track. So sponsors are using continuation funds as a way to ensure they can grow the companies to their full potential. In fact, total transaction volume in continuation funds led by general partners is expected to more than double in 2021 to about $50 billion, up from about $23 billion in 2019. And I wouldn’t be surprised to see that jump another 50% next year. There’s just tremendous momentum behind the supply of these transactions.
Let’s talk about the capital that’s going into these vehicles. What does the landscape look like?
Alexander Mejia: There’s been an explosion of new capital supply into this market driven by both existing secondary market investors raising new capital focused solely on continuation vehicles, as well as new entrants such as family offices and hedge funds who find the risk-adjusted returns of these vehicles particularly attractive. More recently, there has been a wave of activity by some of the world’s biggest asset managers who are now building or buying dedicated secondary platforms with the aim of leveraging existing distribution channels to raise substantial capital focused on the secondary markets. As this market continues to evolve—and I believe that we are still in the early innings—continuation funds could replace a significant portion of sponsor-to-sponsor M&A. As a result, many larger firms are raising capital to find unique ways to access these assets through the secondary market.
And what about the LPs—are they being treated fairly if the sponsors decide to hold onto the assets longer?
Alexander Mejia: LPs are the lifeblood of any sponsor’s franchise so extra consideration is spent ensuring these transactions are designed for and structured with their interests in mind. These transactions provide LPs with optionality—they are presented with the option to liquidate their positions or roll their interest into the new vehicle. In every situation, the sponsor hires an investment bank, such as Goldman Sachs, to run a process and get a fair value for the LPs in that transaction. If there is new dry powder that is invested as part of the continuation fund, existing LPs are also offered the right to participate on a pro rata basis so their holdings aren’t diluted. There is also full symmetry of information in the process so that LPs have everything they need to make an informed election. These are complex transactions with multiple constituents—they require specialization to manage, which is why we have built a dedicated team to focused on this effort. If managed properly, then LPs are treated fairly.