Continuation funds Q&A: Alignment, conflicts, risks and valuations
Christiaan van der Kam and Ankita Baheti tackle some of the common misconceptions around GP-led secondaries, which have become a key topic of mainstay of the global secondaries landscape.
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As we noted in our article on continuation funds in the lower mid-market, and in our recent video explainer, these deals, also known as GP-led secondaries, have become a key feature in the private equity landscape.
In fact, they have accounted for around half of all secondary market transaction volume annually in recent years – and a new record volume of $71 billion of continuation fund transactions was recorded in 2024.
This has, in turn, made them a topic of keen debate – and there are a number of common misconceptions that we hear regularly when we discuss the opportunities in this fast-growing segment. Here we tackle some of the key questions.
Q: Some have queried whether the growth in continuation funds just reflects private equity managers being unable to generate exits in the current market, particularly if they’re fundraising for a new vehicle and seeking to appeal to clients who might be focused on distributions from the prior fund?
Undoubtedly, the exit stressed environment of recent years has increased the appeal of GP-led secondaries. That’s because these deals allow fund managers (GPs) to provide a liquidity mechanism to their existing investors (LPs), while at the same time holding onto key assets for longer to maximise value.
However, continuation funds are also part of the structural evolution of the market as it has matured – evidenced by the steady growth in this segment dating back to long before the recent exit squeeze that began in 2022. In short, as the private equity market has continued to mature and grow, so has the secondaries market by providing innovative liquidity solutions for investors.
The secondary market over time
Past performance is not a guide to future performance and may not be repeated. Source: Jefferies, Greenhill, Evercore, Lazard, Schroders Capital, 2024. The views shared may not lead to favourable investment outcomes. Forecasts and estimates may not be realised.
Of course, for the market to grow as it has there must be increasing buy-side demand as well. Here is where we see some of the key positive attributes of continuation funds come to the fore.
The key reason GP-leds have grown in popularity among investors is that they provide the opportunity to generate above-market returns compared to plain vanilla LP-led secondaries. Our experience, and broader market data, shows that the average underwritten return for a continuation fund is 2-3x net MOIC (multiple on invested capital) and 20-25% IRR.
From our perspective as a secondary investor, to seek that level of return consistently requires meticulous portfolio construction of the highest-quality assets. This brings back to the original question; we don’t want to be inheriting companies that don’t have a straightforward growth path, or that are unable to be exited.
As such, in addition to our standard, detailed due diligence, when offered a GP-led opportunity we independently check with advisers if they have seen this asset as part of previous exit processes – and we discount assets that exhibit ‘stress’ behaviours.
In addition, we also evaluate why it might make sense for the manager to hold the assets for longer – that is to say, what is the upside for the company from here? There needs to be a clear value creation plan that can be realised in the next few years.
Finally, we require the manager to put their money where their mouth is by rolling over their entire carry and exit proceeds to secure alignment. Typical GP commitment for a buyout fund investment might be 2-5%, whereas for a continuation fund it is typically 10-15%, with usually higher hurdle rates to capture any performance fees.
These stringent alignment terms are met because the manager is keen to retain a well understood, high-growth asset for longer, which happens only when they can clearly see the upside the asset can generate in the next three to five years.
Q: In the structure of a GP-led, a private equity fund is essentially selling a company or companies to itself. Does this not raise questions around valuations?
Firstly, and importantly, a continuation fund typically has a new investor setting the price at arm’s length. Secondly, existing LPs generally have the opportunity to either sell their interest in the asset being acquired, or to continue the journey by rolling their proceeds and staying invested.
So, if the price is too high the new investor won’t be incentivised to enter, but if the price is too low existing LPs will not agree to exit. As such there are clear incentives for the new investor to set a fair price, to ensure both that they are not overpaying and that the price is attractive enough for existing investors to take the liquidity on offer and exit.
It is also worth noting that selling at a price below fair value directly affects the performance of the existing fund for the GP. At the same time, selling at a very high price means the GP would have to lock in (and roll over) their proceeds and carry at a non-accretive valuation. Accordingly, GPs will also typically only agree to a transaction if the price is within the fair value of the asset.
Finally, continuation fund transactions often involve independent third party input, either through an adviser running a competitive bidding process with multiple prospective investors, or by the manager providing investors with a valuation opinion produced by an independent agent.
Q: GP-led secondaries are, in effect, a new market being built out where investors are chasing higher returns. Does that mean higher risk?
We find these vehicles may be suitable for investors that are more conscious about target returns, with mitigated risks.
In a continuation fund, ‘blind pool’ and execution risks are much lower than in the case of a traditional buyout, since the company, management team and growth story are all known to the investors. With the removal of so many unknowns, but the same benefits of making concentrated, alpha-driven investments in select assets, continuation funds are able to offer the potential to generate compelling risk-adjusted returns.
It is true to say that you won’t often see the outsized returns that you might see from select 'home run' assets in the co-investment or direct parts of a portfolio. But that cuts both ways, as you would also see minimal write-downs due to the removal of the unknowns and more predictable value creation strategies.
Evidence from realised investments demonstrates that small and mid-cap GP-led transactions have achieved attractive returns while maintaining a favourable risk profile, compared to traditional buyouts. Both the median and mean return for these deals exceeds that of direct buyouts, while there is also a tighter return dispersion and so lower risk of underperformance.
Probability distribution of return multiples (TVPI)
Past performance is not a guide to future performance and may not be repeated. Note: Schroders Capital Data, 2003–2023 (analysis as of December 2024), includes realised transactions only (sample size: 1'855 small/mid buyout, 330 large buyout, 106 small/mid GP-leds). Total value to paid-in capital (TVPI) was calculated on a deal-by-deal basis (gross of underlying fund fees, expenses and carried interest and gross of Schroders Capital fund fees, expenses and carried interest), log transformed and modelled using a smooth double Pareto distribution. The views shared are those of Schroders Capital and may not be verified.
Q: How can the underlying companies continue to grow? Are they not tapped out from a cash perspective and are they just relying on organic growth from that point onwards?
There are many reasons why companies continue to grow in continuation funds. Typically, these deals are initiated by the GP to ensure that cash is not left on the table, for example due to certain value creation endeavours that were initiated during the investment period, but which have not been fully realised. These could be new customer wins, new product launches, entry into new geographies or M&A acquisitions that have not fully synergised.
In other cases, the company may be slightly shy of becoming large enough for an IPO or a target for M&A that could offer better valuations. And finally, some companies will get additional cash in the form of follow-on capital from the creation of the continuation fund, which can be used to kickstart and accelerate the next growth chapter.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
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