Selling to Yourself: Liquidity Farming Via Continuation Funds
If you love something, let it go…right?
Albeit a drawn-out idiom that we have heard time and time again in our relationships (especially when your first childhood pet “goes to see grandpa for a while”), the phrase does pose some meaningful confluence in the world of investing as well. Consider it this way; technical traders and crypto-enthusiasts alike share a love for simple asset price appreciation, and when that supposed price ceiling hits—they will not hesitate to “let it go” and realize their returns. This deep-rooted dogma has historically bled into the nervous system of our friends in the private equity as well—with a few caveats which ultimately introduce the focal point of this editorial; the future of private equity funds and why routinely “letting go” has grown archaic.
This segment of the Queen’s Business Review’s Financial Markets Editorial will provide discourse on the secondaries markets layered underneath classical private equity, and why continuation funds are earmarked to be the opus magnum going forward.
For context, private equity (PE) refers to a constellation of investment funds that invest in or acquire private companies that are not listed on a public stock exchange. So-called PE funds may also buy out public companies, take them private, and then restructure them for potential future growth. Private equity is the quintessential vehicle of alternative investing, providing enhanced return profiles at the cost of enhanced losses, illiquidity risk, and extremely high barriers to entry. To mitigate this, investors often avoid making concentrated bets based on absolute return profile of an investment, rather they predicate their allocations on the concept of risk-adjusted returns, an important consideration for the remainder of the article.
Private Equity Funds, and Why Letting Go Can be Difficult
The archetypal private equity fund has historically followed a relatively straightforward process;
The fund develops a strategy, ranging in consideration of investment characteristics, geographies, competitive advantages, and most importantly, the fund size and duration.
Once the concept has been pitched and been retained by key investors, a.k.a Limited Partners (“LPs”), the subsequent commitment of funds (known as capital calls) initiates the actual raising of capital to be invested by the General Partners (“GPs”) of the fund.
The GPs search for apt investments which align with the funds broader strategy, a process that demands prolonged diligence and can result in limited contact among a pool of candidates.
A deal is agreed upon in which the fund has agreed to take on a minority or majority share in a private company, followed by a series of operational changes to the business, i.e., strategy redirection, management re-shuffling, unwanted cost-cutting, and so on. These changes are introduced in a bid to reach their funds target returns.
In line with the initial exit strategy, and often after a duration of 5 of more years, the GPs will seek out buyers for the investment, typically attracting a multiple of 2-3x of the initial cash outlaid to secure the initial fundraise. This capital is then distributed back to the invested LPs, along with a hefty haircut of management fees and carry returned to the GPs throughout the fund life and upon exit. The illustrious 2 and 20 may be a phrase you’ve heard in this regard, indicative of a 2% annual management fee and 20% carried interest in the profits of the fund.
Exhibit I // A Simple Model by Peter Lynch
You may be thinking this seems like a pretty fool-proof path toward value creation for investors; and you are probably right. So why not just hold on and wait until it is time to let go?
As an LP, there is considerable risk/return asymmetry behind liquidating your stake into a near-perfectly efficient aftermarket when the overarching fund investment strategy has drifted out of your playbook. As financial markets in North America have been swayed by policy malpractice and resulting inflation, pent-up supply chain concerns, and geopolitical conflicts, the QBR editorial saw material value in exploring the ways in which these LPs have been able to let go of unwanted market exposure.
Secondaries Market
Enter the secondaries market, which is attributable to roughly 5 per cent of broader private equity markets, playing the much-needed role of the forgotten middle child. A secondary investment occurs when a buyer purchases existing private assets within a fund from LPs who are often looking for short-term liquidity or to trim underlying exposure to a particular investment stage or underlying asset itself. When this happens, a transfer of interests in the fund via a secondary market prevails, adding another layer to an already elaborate investment scheme. At a 10,000-foot view, secondaries investments allow fund investors to effectively de-risk from their long-term commitments which are believed to have drifted off-thesis.
Everything changed for the middle child when COVID-19 struck—sellers desperately sought liquidity and looked to minimize their concentration risk while hopelessly trying to drop a falling knife before it hits the floor. For secondaries buyers, it provided a chance for high-conviction investors with sustainable balance sheets to make selective fund bets at highly attractive entry prices. Secondaries have gained considerable footing since then, with the total secondaries market crossing $135B in 2021, a stark contrast from the $2B of activity in the beginning of the 2000s and a ~50 per cent increase from 2019 activity. Undoubtedly, the market for secondary investments has grown in scale and outward impact, as many investors have fallen back into the age-old religion of letting go of their troubling investments. But what about letting go of your winners? Seemingly enough, when these fund lives end the GPs must make their sale and ensure ample return for everyone sitting at the table—often so at the expense of their own interest in the long-term upside of winning bets themselves.
Continuation Funds as the Dark Horse Champion of Secondary Markets
Now that we have demystified the idea of secondaries markets within private equity and laid out the central value proposition as an investor, it only seems reasonable to peel back another layer to uncover the true merits of the seemingly championed secondaries’ investment vehicle in continuation funds, and structurally make sense of how you can still hold on to your winners as a GP and still encourage your LPs need for liquidity.
GP-led secondaries (“continuation funds”) are a highly prevalent and emerging path to liquidity for fund managers in 2022 whereby they can extend their holding period of companies within a fund in spite of a premature liquidation/distribution timeframe, and continue to benefit from rolled equity exposure to underlying holdings without having to actively manage or bear option risk on the new investment vehicle. Typically, these continuation funds will be comprised of the best performing assets from the initial fund, and a select group of LPs will be invited to partake in the continued fund life, a decision in which they can also turn away and accept their payout.
Exhibit II // Navigating the Nuances of Continuation Funds
Recounting our guiding thoughts from earlier, innovation within long-underappreciated secondary markets have created an investment opportunity where you no longer must let go of your marquee assets and subject them to your LPs timeframe, instead you can actually repackage them and hold on as long as you would like.
Oh, did I mention you are being paid hand-over first with new cash for it as well?
Evidently, a perfect storm has been formed and investors everywhere brought their best umbrella to weather it up close. In 2021, GP-led secondaries accounted for 44 per cent of all private equity secondary transactions. More than one-third of institutional investors have invested greater than $100M into these vehicles by 1H22, and 7 per cent actually invested a sum greater than $500M. CPP Investments, one of the world’s largest investors in private equity, confirmed it plans to deploy more than $1B specifically into single-asset GP-led deals in 2022.
The incentives that have brought this market to life are buried in the fine print; receiving doubled carry payments (sometimes with “supercarry” clauses), avoiding diminishing management fees associated with long-duration fund lives, and conducting the transaction in a non-competitive manner on your own terms which oft warrants valuation premiums. These managers would be foolish not to take advantage of this newly formed investment vehicle, as they pass along punitive fee-stacking mandates to existing and new LPs while retaining ownership of their pre-eminent holdings—a reality once considered impossible for managers.
As the search for liquidity beats on and de-risking opportunities are limited in prevailing financial turmoil, the secondaries market for institutional capital is patiently waiting in the gates—as they know they have backed a winning horse in continuation funds as the special-purpose vehicle of the future. The age of classical private equity secondary funds is over and been ushered out by their risk-averse, return-enhancing successor, and all they had to do was sell to themselves.