The role of continuation fund strategies in a private equity portfolio
Continuation funds stand as a distinct asset class across private equity.
Autheurs
Private equity investors are constantly seeking innovative ways to maximize performance. Continuation funds, or GP-leds, have evolved over the last 10-15 years to become a permanent pillar across private equity, given their return potential and ability to generate liquidity. This growth has sparked debate among investors regarding how to classify and allocate continuation fund strategies within their private equity portfolios.
Continuation funds stand as a distinct asset class, despite sharing some characteristics with LP secondaries and co-investments. They offer a differentiated value proposition, including alpha potential with a low risk profile and short duration, due to careful portfolio construction and strong alignment of interest between the General Partner (GP) and investors, in addition to specialized teams to underwrite and invest in such opportunities.
Continuation funds vs LP secondary investments and co-investments
Limited partners (LPs) often view continuation funds from a traditional LP secondary investment lens, given their overlapping histories, in which both involve acquiring assets that a GP already owns. However, this perspective overlooks some critical differences.
Continuation funds allow a GP to hold onto a high-performing asset or pool of assets beyond the life of the original fund. This is achieved by setting up a new fund, the continuation fund, to purchase the asset(s) and often to raise follow-on capital to drive further growth and M&A activity. Existing LPs in the original fund can choose to roll their investment into the continuation fund or sell their stake, thereby achieving liquidity.
Unlike LP secondary investments, which typically include a wide variety of assets at different stages of maturity, continuation funds focus on a select subset of assets. This can help to reduce risk, as the GP has in-depth knowledge of the asset and can continue to add value. Continuation funds also realign the GP’s commitment to the new cost basis, whereas an LP secondary investor steps into the existing carry waterfall as it stands.
Although continuation funds and co-investments both involve single-asset investments, their dynamics are quite different as well. Co-investments typically involve a new investment in a company alongside a GP, starting the value creation process from day one. In contrast, GP-leds represent a continuation of value creation that has already been taking place under the GP's management.
This prior history with the asset can be a significant advantage. The GP has an established relationship with the company's management and understands which strategies have worked in the past, as well as those that have not. The GP and management are well-positioned to take a company into its next phase of growth.
Risk mitigation and return potential
One of the concerns raised about continuation funds is the perceived concentration risk, as they involve a select subset of assets, if not a single asset. However, this perspective is often based on categorizing GP-leds alongside traditional LP secondary investments and overlooks how risk can be mitigated through a structured diversification approach.
A continuation fund strategy can include interests in 20-30 different companies, for example. According to portfolio theory, a portfolio of around 20-30 well-diversified stocks can significantly reduce risk, achieving what is known as statistical diversification. This principle can be applied to continuation funds, addressing the concern of over-concentration in a single asset.
Moreover, the continuation fund portfolios are further diversified across GPs, sectors, and vintages, introducing additional layers of non-correlation, further reducing risk.
The careful selection of assets in a continuation fund contributes to risk mitigation as well. Continuation fund investors can hand-pick their exposures at a company level from a market of high-quality opportunities. Also, the ability to position portfolios to withstand higher rates and include less cyclically-exposed assets speaks to risk management.
Another important aspect of risk mitigation in continuation funds is the strong alignment of interest between GPs and investors. A common critique of continuation funds is that they create an inherent conflict of interest, as a sponsor is effectively selling an asset to themselves and crystallizing carry. A well-structured continuation fund has strong GP alignment that enhances its risk-adjusted return profile.
As the continuation fund market has matured, it has become standard practice for GPs to roll 100% of crystallized proceeds into the newly formed continuation fund. GPs demonstrate their conviction even further by making incremental commitments with out-of-pocket capital as well as investing in the same asset from their most recent fund, validating pricing, alignment, and upside potential.
A well-aligned continuation fund sponsor subjects their rolled proceeds to double-jeopardy: they stand to make multiples of their money alongside their LPs if the deal performs, but can also end up with less if it falters. Given that the alternative is a traditional exit where GPs can lock in their unrealized economics immediately, GPs are incentivised to only effectuate continuation funds where they have the highest conviction on generating strong returns.
The market underwrites such performance, targeting at least 2x multiple on invested capital (MOIC) and 20% internal rate of return (IRR) for continuation funds (according to the Lazard Private Capital Advisory Secondary Market Report 2023). This is line with our own GP-led history, which has generated performance of more than 2.5x MOIC on all exits. (This is according to Schroders Capital, 2024, calculated as total realized value divided by the original cost for exited investments at the company level for closed GP-led investments from 2009 to Q3 2023.) Continuation funds inherently have meaningful upside potential given they are constructed to include higher quality assets with robust business models, in addition to GP reinvestment and cross-fund exposures.
Short duration profile and J-curve mitigation
One of the defining characteristics of continuation funds is their shorter investment duration. Most continuation funds are underwritten to a hold period of three to four years – shorter than the typical hold period for traditional buyout investments, which serve as a proxy for co-investments.
The precise portfolio construction of continuation funds further contributes to this shorter duration. In today’s macro environment, continuation fund investors can strategically position their portfolios to help ensure the underlying assets are not overly dependent on long economic cycles, contributing to a shorter overall investment duration.
The ability to “hit the ground running” in GP-leds does not only benefit investors at the end of the holding period, but it can also result in strong J-curve mitigation as soon as the investment is made.
Continuation funds can generate value creation through various levers from the transaction launch through closing, including EBITDA growth, cash flow, multiple expansion and in certain cases purchase price as a discount to NAV.
GP-leds are marketed off a reference date, and the interim between such a date and closing can last up to 9-12 months. Over this period, a strongly performing asset is growing EBITDA and generating cash flow, which when combined with any M&A may warrant multiple expansion.
Some continuation funds also transact at discounts to NAV, depending on the market environment, given that they are providing a certain and accelerated liquidity option vs other exit alternatives. As a result, the implied equity value of an asset can often exceed the purchase price, resulting in a near-term valuation uplift after the initial investment.
The importance of a dedicated, GP-led investment team
A team specializing in GP-led investments brings a wealth of experience and expertise to the table. Their deep understanding of the nuances and complexities of these transactions can be invaluable in identifying promising opportunities and avoiding potential pitfalls.
A dedicated team will have built strong relationships with GPs and other key players in the private equity industry, which provide access to high-quality deal flow and valuable market insights.
GP-led focused teams apply a direct investment mindset to underwriting continuation funds, devoting significant resources and attention to such opportunities. Having a focused approach on assessing transactions on a company-by-company basis, both bottom up and top down, enhances the quality of due diligence and decision-making, rather than splitting a team’s focus across multiple strategies.
Additionally, continuation fund teams can develop and utilize specialized tools and systems tailored to the unique requirements of these transactions. This could include proprietary valuation models, risk assessment frameworks, or portfolio management systems.
A dedicated team will have a track record that can be evaluated by potential investors. This track record can provide evidence of the team's ability to generate strong returns and manage risk effectively in the context of GP-led transactions.
Looking forward
While continuation funds share certain characteristics with LP secondary investments and co-investments, they represent a unique asset class with distinct advantages. By understanding these differences, LPs can make more informed decisions about how to incorporate continuation funds into their private equity strategies.
With more than $50 billion of transaction volume in 2023, the continuation fund market is positioned for robust growth in the coming years (according to data from Schroders Capital). As more and more dedicated capital is raised for continuation funds, we believe experienced GP-led investors will continue to have attractive opportunities to construct high-quality, well-aligned continuation fund portfolios.
Subscribe to our Insights
Visit our preference center, where you can choose which Schroders Insights you would like to receive.
Autheurs
Topics