Continuation funds - some thoughts

Anyone investing private capital in the Caribbean should feel positively about the recent global growth in continuation funds, as it should lead to an increase in deal flow and private capital investing activity in the region. Why? Well first let me explain what a continuation fund is, and describe some advantages and disadvantages / additional considerations. Finally I’ll get into why I think it should be a net positive for the region.

What is a continuation fund, or continuation vehicle? It’s a special purpose vehicle (SPV) created to acquire (usually) a single portfolio company of a predecessor fund. Existing LPs are often given the option to reinvest proceeds from, or roll interest in portfolio companies into the new continuation vehicle. Now, these structures aren’t new, but are a subset of GP-led secondaries. Previously, there was a negative connotation to their use, because it implied that the vehicle’s portfolio companies were somewhat distressed - so they were used sparingly. More recently, continuation funds are being used for strong assets that the GP doesn’t want to (fully) exit yet or assets with strong fundamentals that aren’t growing as quickly, and need more time to develop and realize the value creation plan. As a result of this, their popularity has increased and they have become the most common structure for sponsor led-secondary deals. When you take into consideration that secondary deal volumes have been exploding over the past few years, you come to the realization that the growth in secondaries is strongly correlated to the growth in continuation vehicles. Several of the largest global buyout shops have been raising dedicated continuation funds.

There are many advantages to the continuation fund structure. It addresses the inherent conflict that exists when a GP wishes to retain an investment while the LP prefers liquidity (for example because the fund is nearing end of life). Alternatively, an LP may need to only partially liquidate, if their PE investment has appreciated considerably relative to other asset classes in their portfolio and they need to rebalance their asset allocation. Typically the economics offered to LPs are usually better, over a shorter liquidity timeframe (3-4 years). Of course the LP has the option to not invest at the improved terms and seek liquidity instead, though many argue that the risk profile of these transactions are lower, because the GP has already had 3-5 years of exposure to the asset (compared to a new primary investment for example). Of course the opposing side of this risk argument, is that you have massively increased concentration risk in the new fund relative to the primary fund.. GPs have found the continuation fund structure appealing also, as more capital can be raised to fund continued growth opportunities (e.g. for new equipment purchases, or bolt-on acquisitions). It gives GPs some needed flexibility on holding periods of portfolio companies, and because they are providing liquidity options, it helps GPs to increase the ratio of distributions over paid-in capital on the existing funds - which helps with future fundraising efforts. It doesn’t hurt that the transaction allows the GPs to simultaneously capture some of the carried interest on the assets that transfer, as well as reset the economic terms with the introduction of a new fund. Indeed, even portfolio company managers can receive some proceeds, usually up to 50%, without the concern of having to deal with a totally new sponsor (as they would with a traditional secondary).

Continuation fund transactions aren’t without their pitfalls however. Notably, at the essence of the transaction, there is a conflict of interest, as both the selling fund and the buying fund are controlled by the same GP. This of course raises questions about governance, and most importantly, about valuation. Many LPs note that valuation of the assets being transferred is one of the biggest challenges, complaining that there are relatively short time frames offered for decision making, especially taking into consideration that some of the diligence efforts now sits with the LPs (vs a traditional blind pool where the GPs handle all diligence work).

In order to create greater comfort around the transfer process, governance and transparency, large PE sponsors have started getting independent 3rd party valuations annually. GPs can also commission a fairness opinion to augment the GPs own diligence process and provide evidence of a thorough, exhaustive process. Some GPs also have a formal Investment Committee review occur when considering a Continuation Fund transaction. The Investment Committee review looks at the historical financial performance of the portfolio company, and forecasts of future performance, as well as assessing growth opportunities and risk factors - basically the same level of diligence that would occur for a new investment. Typically multi-asset transactions have proven less popular among LPs given the difficulty in quantifying the risk of each individual company, as well as the complexity in allocating LP funds across each individual company proportionally (vs pooling). The LPs also need to carefully weigh how much capital the GP is rolling into the new structure, the exit vs roll status of other LPs as well as the willingness of new LPs to join the Continuation Fund.

Co-investors in a fund also have additional considerations if a continuation fund transaction takes place. Depending on the specifics of the LPA, the continuation transfer could either fall under the “affiliate transfer” clause and either be guided by the general alignment principles (or not). Which means that some co-investors would assume that they would participate in the transfer on the same terms and conditions of the sponsor’s primary fund, while other co-investors might remain in the primary fund, or might demand the same terms and economics of the primary funds LPs. Each case is going to unique - however it’s expected that going forward, most LPAs will address continuation fund transactions directly. Finally it should be noted that depending on the industry and size of the companies in question - regulators can become displeased with the resulting portfolio transaction. Several industry participants have complained of continuation fund transactions with portfolio companies that were so big, that antitrust and anti-competition issues were raised.

For many of the above considerations, industry best practices have not yet been fully established, as the growth of continuation funds has been so explosive in the last 18 months, that industry practitioners have not had a chance to catch up.

Why does any of this matter to the Caribbean? Because I think that the continuation fund structure could indirectly lead to more private equity activity in the region. It’s already known that one of the issues preventing more private capital inflows into the Caribbean are lack of available exit options. Typically PE exits a position via a sale to a strategic, or by going public. Since most of the region’s equity markets are too small and illiquid, going public really hasn’t been an option until very recently. Recently with the growth of the Jamaica stock market, especially the Junior market, we’re seeing more interest in public markets generally from the private sector, as well as a few more Caribbean focused PE funds (mostly out of Jamaica), with the playbook to acquire a private company, execute the growth plan and then partially or fully list on the Junior JSE, giving the LPs a healthy exit - as long as equity markets are flying high. Now, the continuation fund structure allows existing PEs with portfolio companies that need a little more time, to run the same continuation fund playbook that’s being used globally (annual 3rd party valuation, fairness opinion etc) in order to give some LPs some liquidity, as well as potentially attract new LPs to a lower risk investment. In providing liquidity to some earlier LPs, the DPI ratio improves, which helps the fund with future fundraising. Ideally, the increased length of time, allows the portfolio company to return a value close to what was planned by the PE sponsor. More positive outcomes tend to attract more LPs and emerging managers interested in the region, leading to more private capital to fund company growth.

I would be very interested to know of any funds in the region who are contemplating the continuation fund strategy. Or let me know where my analysis is faulty. I would love to hear any opposing viewpoints.