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A Closer Look at Continuation Vehicles in Private Markets

Few Limited Partnerships take advantage of continuation vehicles, despite the strong performance1 of these secondary transactions. A lack of available capital to commit due to the denominator effect is one of the reasons LPs decide to take the liquidity option. Lacking the processes to vet these transactions is another reason LPs choose to sell. Extensive knowledge of the landscape and the resources to perform due diligence reviews are necessary to take advantage of these vehicles and ensure strong alignment of interests between General Partners and Limited Partners.

Private Markets Continuation Vehicles: What are they?

Liquidity is one of the most important factors in investing and it can be challenging to find with private market assets. With the typical private equity commingled closed end fund, investors generally wait several years before they see a positive return on their capital and may wait 10+ years for the fund to fully liquidate. A secondaries market has evolved over time and is generally split into Limited Partner (“LP”) led deals in which LPs sell their interests in a PE fund to other investors and General Partner (“GP”) led deals in which GPs offer liquidity to LPs.

A Continuation Vehicle (“CV”) is a secondaries structure in which GPs transfer assets from a fund that is at the end of its term into a new fund. It allows the GPs to retain and re-invest in quality assets with growth potential, while providing a choice to LPs to cash out (“sell”), take an equivalent ownership interest in the newly created fund (“roll”), or to do a bit of both (“sell and roll”).These funds are created to acquire either a single asset or multiple portfolio investments of a predecessor fund as shown in the illustration below.

Figure 1: Continuation Vehicle Structure

What has driven the growth of CVs?

From less than $1bn of deal volume a decade ago, CVs have come a long way with a more opportunistic outlook and efficient processes. Traditionally viewed as a means to hide underperforming assets, CVs today are used for many different reasons. CVs are a tool to offer flexible liquidity solutions to stakeholders, inject capital in known and high-quality assets, allow sponsors to reset the carry, allow new LP’s to get immediate and concentrated exposure to assets with a shorter duration and tapered J-curve.

Triggered by the pandemic, CVs are now looked at as a viable alternative exit path to IPOs, trade sale and traditional secondary sale. After recording a ~140% growth in H2 ‘20 vis-à-vis the same period the year before, GP-led secondaries continued their strong growth in 2021 with $68bn worth of transaction volume (Figure 2) of which ~84% were CVs. The trend is expected to continue in 2022 and beyond as both transactions and distributions slows in the face of rising inflation, shrinking valuations and a volatile market.

What are the characteristics and structure of CVs?

Single-asset deals comprised the 52% of all continuation vehicles in 2021 and were trending close to ~70% during the six month period between Q4’21 and Q1 ’22. With private market valuations decoupling from public counterparts, it has become increasingly difficult for secondary buyers to determine fair value. Moreover, the price war between selling LPs looking for higher exit value and rolling LPs demanding a lower entry value can be hard to resolve. Transparency, third party valuations, and fairness opinions are helping address these conflict of interests.

To ensure that GPs’ interests are well aligned with LPs’ interests, an analysis of the CV’s terms with a focus on the GP’s re-investment and carried interest structure is of primary importance. Ideally, the GP should be rolling 100% of their investment from the prior fund into the continuation vehicle. Similarly, the GP’s investment should comprise 10% or more of the total capital. In addition, a tiered carried interest mechanism (e.g., 15% carry over 8% IRR; 20% carry over 15% IRR). motivates GPs to retain quality businesses that are well-positioned to sustain the second phase of value creation. With an opportunity to earn higher return and additional time, GPs can pursue accretive acquisitions.

The CV Conundrum

According to a Hamilton Lane 2021 research report, both single asset and multi-asset continuation vehicles have outperformed their parent funds. Additionally, CVs overall have consistently given better returns to LPs than top quartile funds in the same year.

Notwithstanding strong performance of CVs, more than 80% of LPs have cashed-out of their positions since 2020. Aside from the potential merits of the investment, LPs may have separate considerations including a lack of available capital to commit due to denominator effect or an abundance of other good opportunities. Specific to the continuation vehicle opportunity, investors might be hesitant to invest and risk a strong return on the investment to date and/or re-investing at a higher valuation. They may not need additional exposure to the manager, sector, geography or vintage. Alternatively, they may be re-upping in the same manager’s new fund for a more diversified approach to the same strategy. In addition, LPs may not be staffed to underwrite a deal specific or seeded portfolio continuation vehicle that requires a level of due diligence equivalent to a direct or co-investment deal.

In the current environment of decreased transactions and slow fundraising, the terms offered for continuation vehicles could be even more compelling than in recent years. Only time will tell if LPs have missed out on potentially higher returns that early data indicates continuation vehicles can provide.

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