Continuation Funds and their Role in the Private Equity Market

published on 23 October 2024 | reading time approx. 5 minutes

Continuation funds have gained significant prominence in recent years and have become an established strategy for private equity (PE) funds. In times of limited alternative investments, they offer a solution to the traditional dilemma of having to sell assets when a fund’s typical lifecycle ends, often before the assets’ full potential has been realised. This is particularly relevant for investors who prefer long-term investments in mature and already established assets. While supporters view continuation funds as a “win-win-win” scenario, critics argue they could distort the market. This article explores whether continuation funds truly represent an efficient market tool and a sustainable approach. We examine their mechanics, the opportunities and benefits they provide for investors, as well as their limitations.

Continuation funds are specialised fund structures that allow portfolio companies to be held beyond the typical lifecycle of a PE fund. Unlike traditional funds, where investments must be sold after a set period, continuation funds offer the opportunity to continue managing assets and extracting further value from them. These funds acquire stakes from the original fund, often bringing in new capital to support further growth of the companies involved.

In contrast to traditional PE funds, which typically invest in a variety of new and unknown companies, continuation funds focus on specific portfolio companies that have already been successfully developed. These funds feature a clear investment strategy, allowing investors to back an already-established company rather than allocate capital to new and uncertain investments. This structure facilitates more efficient management and cost-effective continuation of ownership, concentrating on already successful businesses, which improves predictability and reduces both fund lifecycles and management fees.

Opportunities for General and Limited Partners

One key advantage of continuation funds is the ability to extend the holding period of port-folio companies. This allows general partners (GPs) to continue working on value creation without the pressure to sell. Particularly during periods of strong growth, continuation funds provide the time needed to implement further operational and strategic improvements.

Additionally, continuation funds offer GPs significant flexibility. They allow the raising of capital for specific portfolio companies that still exhibit strong growth potential. This flexibility permits the reassessment of a company’s strategic direction, the pursuit of potential acquisitions, and the exploration of growth markets that may not have been feasible within a traditional fund structure.

Limited partners (LPs) also stand to benefit from the transfer of portfolio companies into a continuation fund. For investors, this offers a valuable liquidity option: LPs can choose to exit by selling their stakes or transfer them into the new fund. This is especially attractive for institutional investors with fixed return deadlines, investors with limited risk tolerance, or those looking to reallocate into different sectors or strategies. Moreover, new and existing LPs have the opportunity to invest in attractive portfolio companies that might otherwise have been sold to strategic buyers and thus no longer be available.

Current Market Environment and Its Impact on Continuation Funds

Given the current economic landscape - characterised by macroeconomic uncertainties, rising interest rates, and increased market volatility - continuation funds have become even more critical. Whereas in previous market cycles rapid exits were the preferred option, it may now make more sense for GPs to hold companies longer, allowing them to realise full value in a more favourable market environment.

In times of depressed valuations, continuation funds can help GPs and LPs avoid suboptimal sales. Instead, they can strategically extend their holdings, waiting for more favourable market conditions to conduct an exit at a later stage, once the market has recovered. The ability to react flexibly to market cycles makes continuation funds particularly attractive, enabling GPs to focus fully on value creation without the pressure to sell.

Impacts on Stakeholders' Interests and Incentives

The structure of continuation funds can lead to better alignment between fund managers and investors. With an extended holding period, managers have a greater incentive to create long-term and sustainable value, as their compensation is often tied to the performance of the continuation fund. For investors, this potentially translates into higher returns and a reduced principal-agent problem.

Challenges and Costs of Transferring to Continuation Funds

The transfer of assets into a continuation fund is inherently associated with costs. Since this usually involves the creation of a new fund, a detailed and independent valuation as well as due diligence is required. While this increases transparency around the portfolio companies and their valuations, it also brings into play different interests. Investors seeking an exit will desire the highest possible valuation for their portfolio companies, whereas new investors will prefer a lower valuation to maximise their profit potential at a later exit.

The fair value of portfolio companies should be determined based on common valuation methodologies, such as the multiples method or the discounted cash flow (DCF) method, taking into account growth potential, market conditions, liabilities, and potential risks. A thorough and independent due diligence - encompassing financial, tax, and legal aspects - is also essential, particularly as a change in the investor structure is often involved. In many cases, a Warranty & Indemnity (W&I) insurance policy is taken out when transferring portfolio companies into a continuation fund, to cover potential risks such as warranty claims.

Implications for PE Firms and Their Returns

Given the current market environment, it is particularly important for PE firms to weigh up whether transferring into a continuation fund vehicle is worthwhile. Considering the significant time and cost involved, clear expansion plans should be in place. PEs face pressure to sell portfolio companies in order to remain attractive to future investors. Since primarily high-performing portfolio companies are transferred into continuation funds, this defers profit realisation for the PE, which could impact historical returns and potentially diminish appeal for future investors.

Conclusion

Continuation funds offer PE firms and investors a valuable opportunity to extend the holding period of companies, thus ensuring sustainable value creation. They provide flexibility to respond to market conditions and offer investors a range of options - from liquidity to reinvestment to long-term growth potential. Despite the challenges involved, such as additional costs and the complexity of the transfer, continuation funds are gaining in importance due to market volatility.

In the current market environment, marked by rising interest rates and a sluggish IPO market, PEs are finding it difficult to sell companies. This increases the pressure on firms to divest portfolio companies and realise returns. As a result, continuation funds are not always a sustainable tool. Given the upfront costs, it is essential to carefully evaluate whether to utilise this instrument. However, the relevance of continuation funds could increase in the coming years as long-term value creation returns to the forefront.