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- [00:02]
A
A rose by any other name would smell just as sweet. You may remember this famous line from the play Romeo and Juliet. In it, Juliet argues that it does not matter that Romeo is from her family's rival house of Montague. It suggests that the names of things do not affect what they really are. As a journalist covering the private equity secondaries market, we often spend our days wading through press releases filled with jargon and marketing speak. Liquidity Solutions is my personal favorite. We also tend to notice when there's a deliberate change in language within the beats we cover. A decade ago, when assets were moved out of an existing fund and into a separate fund backed by Secondaries Capital, it wasn't uncommon for it to be referred to as a fund restructuring. The original funds the assets were housed in were sometimes referred to as zombie funds, suggesting that the original vehicle was some sort of revived corpse that probably died a long time ago. At some point over the last 10 years, I put it at around 2018, the phrase continuation fund or continuation vehicle started to pop up. This phrase started to appear more frequently and consistently in press releases, during interviews, at conferences. I don't know if someone was making a deliberate attempt to change the industry discourse, but I do know that people stopped using the phrase fund restructuring and started using the new parlance. I can see why the word continuation has more of a neutral you might even say positive meaning than restructuring, which generally suggests something has gone wrong, like when a company is forced to restructure. I'm Adam Ley. I'm a senior editor at PEI Group and editor of our Secondaries Investor title. Welcome to the Decade of Secondaries Investor miniseries. This is Episode two, the Rise of Continuation Funds. Today, the continuation fund market is worth around $40 billion in annual trading. Some of the biggest private equity firms have used continuation funds to hold onto assets and attract fresh capital to invest in companies they already hold. In fact, if you look at the top 20 private equity firms as per the PEI 300 ranking, which you can find on privateequityinternational.com or at the link in the description, more of those firms have used continuation funds than those that haven't. But back in 2014, this market looked a little different.
- [02:22]
B
I remember very distinctly going out for breakfast with a good friend of mine who will remain nameless but is head of fundraising for a large institution. And I told him I'm thinking of starting an advisory business in the secondary market, and he said very clearly that it was the single worst idea he'd heard that year.
- [02:41]
A
The voice you just Heard is Nigel Dawn. He's global head of private capital advisory at Evercore, one of the biggest financial advisory firms in the secondaries market. I sat down with him and Vern Perry, who leads Blackstone Secondaries Business. The pair know each other pretty well. They've both been advising on and executing on secondary's deals since the dawn of the market. Forgive the pun.
- [03:03]
B
We thought at the time that it was a pretty meaningful market. I mean, I for one had no idea where we would get to today and you know, instill, I mean, when we think about the trajectory ahead, which is, you know, staggering in some ways. It was still early days and the technology in a sense for LPs was fairly well developed. For GPS, it was still pretty early. So, you know, it didn't feel like a huge risky move, but it wasn't. The upside wasn't, certainly wasn't clear to me at that time.
- [03:29]
A
According to dawn, the technology used to move assets from one vehicle to another vehicle and create liquidity for the original vehicle, resetting the time the GP economics and potentially adding additional capital to the new vehicle. This wasn't exactly new in 2014. He says that as early as 2006 he was advising on spinouts of private equity teams from banks that use this kind of technology. In other words, moving assets out of an existing vehicle into a new structure. Crucially, moving assets into a new structure meant bringing on board a whole new set of economic terms and potentially some new capital, which would help reset the alignment between fund manager and investors in the new structure. Here's Vern Perry from Blackstone.
- [04:13]
C
In the early days, the zombie fund really described a situation where a GP had run out of time, had run out of incentives, either because they hadn't achieved them or they had run out of management fee streams. But the most important part is they needed more time. When you look at the market today, I'm sure we'll talk about it in a moment. The high quality, highly aligned GPS that we're seeing in the market today, the GPS today though, they want more time. They don't necessarily need more time. They want more time with a high quality performing asset. These assets are coveted. These are marquee assets that frankly the GP knows well. They've owned it for three to seven years and they want more time because it's been a gift and the gift keeps on giving. They want more time to generate more value for their LPs. And so there's a huge transition from GPS needed, needing more time to turn an asset around or to try and Create value to get above a certain level to gps, wanting more time to add additional value to an asset that has already generated tremendous growth and value.
- [05:17]
A
So if the language we use to describe these processes, zombie funds, fund restructurings, continuation funds, has evolved over time, how do we know that the current popular use of continuation fund is going to stick? Is this really the best way to describe what's going on? Dawn reckons it is. He says that it really is the GP continuing what he calls the journey with the asset.
- [05:40]
B
When I used to ask a lot of managing partners, they would say one of the frustrations is that I have to sell my best assets to generate distributions to my investors, so then they will reinvest in my next fund. And many would say if I knew about this technology five to 10 years ago, I wouldn't have taken my best assets and in some cases sold them to another GP and watch that GP or another buyer generate a great return. So there's a sense that I've done all the hard work with the asset. I've got a great management team, we like working together. So rather than be forced into selling prematurely, I want to give an opportunity both to my existing investors and potentially new investors to participate in the next leg of growth for the company. So that's the continuation. So these are not turnaround stories. This is not about investing in a brand new line or a brand new sector. This is about continuing a great story that started generally with your same investors or new investors coming in but not having a change.
- [06:52]
C
I couldn't agree more. When you think about the term continuation, it's to me precisely describes what is happening when you think about this setup. Compared to a brand new acquisition for a GP, the GP's just bought an asset. New leverage, new business plan, new management oftentimes versus a continuation opportunity where they've already owned it, like I said, three to seven years, it's performed wonderfully, they know the management, they've already pulled the valuation levers, a lot of the valuation has come through, but there's a lot more valuation upside to come. And Nigel's point about oftentimes seller regret they've sold and they look at the next buyer three, four years later, sitting on a three times unrealized moic.
- [07:36]
A
Moic, that's multiple on invested capital or the ratio of money received relative to the amount of money invested. A MOIC of 2.5 means someone has received two and a half times their initial investment back to Verne and they're.
- [07:51]
C
Thinking to themselves, wow, if I could have held longer, all of that value upside would have gone to the benefit of my LPs. So when we talk about continuation, we're talking about it from two perspectives. The GP's perspective they want to continue their journey, but it's from the LP's perspective as well.
- [08:08]
A
The LP's perspective, that's an interesting one. Over the past 10 years we've written ad nauseam about the conflicts of interest that arise out of these transactions. In the words of ilpa, the Institutional Limited Partners association, and I'm quoting from their website, these transactions are inherently conflicted, with GPS sitting on both sides of the transaction. The lack of language generally included within the limited partner agreements create a difficult landscape for LPs to navigate. It's worth noting here that ILPA has published best practice guidance for LPs on how to deal with continuation funds. The best questions to ask, red flags to look out for. But ILPAS guidance didn't always exist, and over the past decade LPs have voiced their frustrations when they've felt they've drawn the short straw when it comes to their GPS running a continuation fund on their own assets. I asked Perry and Dawn whether they think continuation funds are always a good option, and if not, in which cases are they probably not a great option?
- [09:07]
C
This isn't an exhaustive list, but here are a couple examples where continuation should not be used. The GP has held the asset for two years or less. There are seven years remaining in the life of the fund, so there's plenty of time to add value, add acquisitions. Decide what you want to do with the asset. The asset hasn't performed, so the asset hasn't performed over the hold period thus far, and you're looking to go out and market it to a pretty sophisticated investor base that wants to buy in. You're not going to get a lot of interest for a poor performing asset that you've held for, let's say six years and it's being held at a 0.8 MOIC. They're going to look and say what's going to what are you going to do differently over the next seven years? Five to seven years versus what you did over the last five to seven years. And then, you know, finally, if there's very poor alignment. For example, if there was a case where GP said I'm going to crystallize my gain, I'm not going to reinvest in the continuation fund, or I'm not gonna put new money in with my most recent fund, that is there's poor GP alignment, it's probably not a good use case for these structures.
- [10:14]
B
I think they're great examples. Maybe. One other thing I would add recently is if a GP has tried to sell a company and has not been successful or has not achieved the valuation that they desire, and if I sometimes hear that I took the asset to the market and really no one could understand the value except me, well, people are pretty smart in this business, so my sense, they did understand the value, but it's not the one you want. So that is often not a great case to get people excited about the continuation funds.
- [10:48]
A
So those are cases where continuation funds probably don't make sense. What then are the ingredients for a successful continuation fund? If you're a gp, how do you know what an advisor will be looking for when they're thinking about taking on your mandate?
- [11:02]
B
I mean, we look at a few things. One is, what's the quality of the gp? Is this a great gp? Have they performed over time? Do the buyer community know them and they trust them? Have they done what they said they would do, you know, in the past? And then we would look at the company, is this something that's going to be interesting to the market? And are the valuation aspirations consistent with what the secondary market would want to pay? And then I think what Verne hit on is the alignment proposition with the gp, that if you have a GP who doesn't want to roll any of their capital into the transaction, that should be a huge red flag. So is the alignment good, is the company good? And is the go forward story interesting enough from a returns perspective to justify the valuation the GP desires? And usually, I mean, Vernon and I were talking about this continuation. Often that additional capital is raised to continue investing in the company and that could be to fund an acquisition program. So you want to see the growth going forward so the continuation investors can generate an attractive return alongside the existing LPs who decide to roll over. And of course making sure ultimately that the incentives that are provided to the GP by the lead secondary investor are consistent with them being motivated too. So all these aspects really have to align to generate a good transaction.
- [12:29]
A
So several elements have to align to make for a good transaction. But surely the ultimate litmus test is whether LPs have benefited. If I'm an LP and I choose to roll my exposure into the continuation fund, can I expect to make a good return? What does a good return look like? Can I expect a return that's similar to committing to another secondaries fund, or can I expect a return that's similar to Committing to a blind pool buy as of early 2024, some research findings are beginning to come out that seek to answer these questions. Morgan Stanley's private capital advisory group, led by Chad Carroll, and Evercore's private capital advisory group led by dawn, who we've been hearing from in this episode, have both published data this year shedding light on how continuation funds perform. You can find detailed analysis of their findings on secondariesinvestor.com or at the links in the description. To some extent the jury is still out on these questions and dawn and Perry say it's still early days. Continuation funds are still young in terms of vintage. However, they point out that the ingredients for these transactions to be successful are there.
- [13:36]
B
What we do know is that gps are selecting what they consider their best assets with the greatest growth prospects. So given that positive selection bias and that really compares with a co investment where a GP investing in a new company that they don't know it could be the best or worst performing asset in their fund, they just don't know. But the selecting something you already know and the management team you trust and a company performance that you've come to know and believe in the future we would expect that that would provide good private equity returns. And so the belief, and I think the early results are showing that it's not surprising that if continuation funds have some of the better performing assets, you would have good performance coming through.
- [14:26]
C
I would just introduce the concept of let's not just look at the return, let's look at the risk adjusted return because what's going to happen is over time, inevitably people are going to look and say I'm going to compare a GP continuation or a fund continuation opportunity to a new setup. It's very different risk profiles. So said another way, let's say a brand new acquisition returns X and a continuation opportunity returns the same irr, same moic. Are they created equal? I would argue no because one the GP knew it, was very familiar with the asset, held it for three to seven years, knew the valuation levers, knew the management had a business plan in place and they're just continuing that journey. It wasn't new, it's not a new setup, it's an older setup, but a continuation. I would argue that the standard deviation on that should be lower, the risk should be lower. We'll see when the returns start to come out a few years from now.
- [15:27]
A
In other words, it's important to take into account the fact that the concept of secondaries is to mitigate blindfold risk because you already have exposure to existing assets. And that's something important to take into account when evaluating the returns of continuation funds. As more data becomes available about the performance of continuation funds, and if the data does support the notion that continuation funds can facilitate positive growth stories, I do wonder whether there is a risk that LPs who previously sold off their exposure in continuation fund processes may experience a bit of seller's remorse as the secondaries industry moves towards becoming a more standard liquidity mechanism in private markets. Is this something it should be focusing on and thinking about?
- [16:11]
B
I think it's important to understand performance over time, but also I think the option that is provided to the LPs in terms of whether they want to sell and usually remember they're crystallizing a good return so they're taking a great return off the table, or whether they want to reinvest alongside the GP and continue.
- [16:33]
A
Dawn says ILPA's guidelines have been generally helpful, particularly its guidance for status quo options.
- [16:39]
B
I think LPs being able to evaluate whether they would prefer liquidity or whether they think continuing to invest with this asset or assets is a good thing, or whether they want to do both, maybe they want to take some cash off the table and reinvest, they could take their basis off the table. So the options provided to LPs need to be good and the alternative is the GP just sells the asset and then the LP doesn't have any choice at all. So in some ways this is an enhanced option for an LP, particularly because all LPs are not created equally. Some have very, very long timelines and maybe they would like to keep an asset forever. Others may prefer to get some distributions today. So it's a good question, but it's a nuanced question.
- [17:25]
C
It is nuanced and I would argue that your question argues in favor of this technology because they're going to be a large subset of the LP base that says I don't want to sell, I want to hold on. So imagine a case where the example where you use where an LP chose liquidity and you know, four years later it's a five times moic. Imagine if that GP had to sell outright, so all of the LPs would have missed out on a five times MOIC. But the LP has the power of the election. They have the option to hold or sell. And let's be clear, let's not look at this in a vacuum. If they choose liquidity and they miss out on a five times MOIC going forward, they didn't just take liquidity and put it in a mattress. They took that liquidity and there's value and liquidity. They reinvested in something else. So the opportunity cost wasn't they missed out on a five times moic. It's the five times MOIC versus what they ultimately invested in.
- [18:19]
A
The jury may still be out on returns from continuation funds, but this market certainly seems like it's got more room to grow. In one study by investment bank numis Last year, UK mid market GPs ranked continuation funds as their most preferred exit route, more so than IPOs and private auctions. More LP capital is expected to flow to backing continuation fund processes too. When we surveyed LPs for our annual PEI LP Perspectives report at the end of last year, roughly half of respondents said they either already invested or would like to invest in the types of funds that back continuation fund processes. That figure is up from just below 40% when we surveyed LPs the prior year. Both dawn and Perry expect there's more growth in store for the continuation fund market, but it's not necessarily going to be a fait accompli.
- [19:11]
C
I think the big constraint on the growth in this market is capital, frankly. There are only so many buyers that are willing to put large checks into single asset continuations or have the ability frankly to understand the technology and execute because maybe they don't have the skill set or they don't have the capital, but I think the capital is what's constraining the growth.
- [19:32]
B
I think that's right. I mean, adding onto that, that ultimately will be the performance of the vehicles. And if they perform well, capital's the issue. But capital will be attracted to the asset class because performance is there. So ultimately, if these vehicles do well as the overall secondary market, the overall secondary market will grow and in a sense it's accelerating away now. So I think we can already see it.
- [19:56]
A
In our next episode, we'll take a look into the growth of the single asset secondaries market.
- [20:01]
D
I am a little surprised at how much the industry has grown. I actually think there's still a lot of room for growth because I think the people that are in this industry really view themselves as having a mandate of being a liquidity provider, very broadly defined. And when you look at the denominator of illiquid assets and the growth we've seen in that part of the market, I think there's still a lot of opportunity.
- [20:25]
A
That's Harold Hope, Global head of secondaries at Goldman Sachs Asset Management, talking about the room for innovation over the coming years following a Decade of Creativity from the Secondaries market on the next episode of the Decade of Secondaries Investing miniseries. The production editor on this mini series was Evie Rusman, and our audio editor is Eric Fish. For links to the several articles we mentioned from Secondary's Investor in this episode, be sure to check the description or head straight to secondariesinvestor.com For PEI and secondaries investor, I am Adam Lay. Thanks for listening.