Stars align for continuation funds to thrive

A small but growing corner of the private markets secondary market — continuation funds — might expand as managers look for liquidity for limited partners in a time of few transactions.

In a continuation fund, general partners sell a portfolio company or other assets to a brand new fund that the GP creates. The GP tends to also bring new investors into the continuation fund, including managers that invest on the private capital secondary markets.

Limited partners in the original fund have the choice of cashing out or, if they like the asset, rolling over their interest into the new fund. For the manager, this starts up management fees all over again — and it also could create a conflict since the GP is both the buyer and the seller of the asset or assets.

The stars may be aligning for continuation funds, which are a form of GP-led transactions, a newer and smaller portion of the market than traditional secondary market sales of limited partnership interests, industry insiders said.

"We've seen a pickup in GP-led activity in the early part of 2023," said Eric Foran, New York-based partner at private market secondary market manager Coller Capital Ltd.

General partners that are not managers of funds of funds or secondary market funds accounted for 35.7% of the sellers in 2022 from 27.3% in 2020, according to data from Toronto-based private capital secondary market broker Setter Capital Inc.

The GP-led part of the private capital secondary market "allows GPs to partner with management teams for a longer period and raise follow-on capital to support the companies, while also providing LPs with a liquidity option should they want it," Mr. Foran said.

Eighty percent of GP-led transactions in 2022 sold for 90% of net asset value, while only 38% of LP secondary market deals priced at 90% of NAV or better, according to a report by Campbell Lutyens, a global secondary market advisory firm.

Some investors are pressing their private capital managers to offer them a way to get some of their money out, he said.

"Exit pace has dropped and hold periods are being extended, so LPs are asking for liquidity because they are not getting distributions," Mr. Foran said.

Coller executives are also seeing an increase in tender offers, he said. These offers are not for continuation funds but they are part of the GP-led market, Mr. Foran said.

"A tender offer is where a secondary market buyer offers to buy LPs' interests in a fund. LPs can sell or not sell," he said. If the LP decides not to sell, the LP remains in the original fund with the existing fund terms.

Many tender offers have what are called "staples" associated with them in which the secondary buyer not only buys the LP interests in the fund it made the tender offer for, but the buyer also makes a commitment to the GP's new fund," Mr. Foran said.

It is a way for a private capital manager to kick-start fundraising of a new fund, which is especially valuable now when GPs are having a harder time raising funds, industry experts said.

Michael J. Arougheti, co-founder, CEO and president of Ares Management Corp., expects the secondary market to take off in 2023.

General partners that are in between funds or are finding it taking longer to raise new funds are crafting GP-led and continuation fund transactions, Mr. Arougheti said during Ares' first-quarter earnings call on April 28.

While the number of continuation funds being offered to investors has dwindled in the current rocky market, activity could pick up "as the fundraising market has declined and exits have slowed," said Steven Hempler, San Francisco-based managing director and senior private markets consultant at Verus Investments.

"GPs are looking for exits and LPs are looking for liquidity," Mr. Hempler said. These transactions should continue "and even grow," he added.

For funds not needing liquidity, rolling over their interest to a continuation fund is attractive because it allows them to stay invested in well-performing assets.

"It's a good thing for LPs to get liquidity and a good thing for GPs to hang onto good assets rather than hand them over to another GP to get the upside," Mr. Hempler said.

But most LPs cash out in continuation fund transactions that he has seen, Mr. Hempler said.

"The majority of our clients do take the liquidity," he said. Some LPs take it because they are overallocated to the asset class.

The percentage of LPs that take the liquidity has grown over time to about 80% most recently from 50% historically, Mr. Hempler said.

However, these deals need to be carefully scrutinized by LPs, he said. The Securities and Exchange Commission is looking at them to ensure they are fair, including if GPs are getting a third-party fairness opinion since the GPs are both the seller and the buyer in continuation fund situations, Mr. Hempler said.

Verus executives scrutinize these deals to make sure that the GP isn't "taking money off the table" by pocketing its share of the profits in the continuation fund transaction rather than rolling its carried interest into the continuation fund, Mr. Hempler said.

Some investors cash out their interest in the fund because they don't think the fund will generate return and think they will be able to invest it elsewhere and get a better return, he said.

In the past, managers used continuation funds to exit their losers, said Brian R. Forman, New York-based partner and chairman, investment funds and advisers at law firm Morrison Cohen LLP. That is no longer the case, he said. Continuation funds have evolved into vehicles to raise more capital for good companies in a deal in which the investor can get a fair choice as long as the manager has a third party provide a true valuation, Mr. Forman said. Investors that roll their investment into the continuation fund would get the same terms as the original fund, he said.

Ares' Mr. Arougheti said that investor overallocation issues have "LPs seriously looking at liquidity on the secondary market."

"I would expect 2023 would be a record year for LP-led secondaries" based on what Ares executives are seeing today and how they see the market developing, Mr. Arougheti said on the April 28 earnings call.

Elizabeth Traxler, a New York-based managing director at Neuberger Berman Group LLC, agrees that limited partners could be looking seriously at the secondary market.

"The traditional secondary market for most LPs was a last resort because they had to take a substantial discount," Ms. Traxler said. "We're seeing a lot of price discovery and traditional LP volume in the market."

At the same time, Ms. Traxler said that private market managers are continuing to look for GP-led deals and other liquidity options.

"GPs don't want to sell if they can optimize value … and lock in an attractive return," she said.

Continuation funds also are more common these days, in part, because most managers do not wrap up their funds' once-expected 10- or 12-year lifespans on time, she said. LPs are sensitive to GPs taking longer to close down their funds with distributions dwindling over time, she said.

Another motivating factor for manages is that mergers and acquisitions are down and expected to stay down in 2023, said Mina Pacheco Nazemi, head of Barings LLC's diversified alternative equity business, which creates customized private equity and real assets solutions across co-investments, secondaries and primary funds.

GP-led transactions are a way to raise additional capital or "crystalize some of their gains" while continuing to invest in their winners, Ms. Nazemi said.