Why the lower mid-market offers compelling continuation fund opportunities
Continuation funds, otherwise known as GP-led secondaries, are a growing trend that is here to stay – and the highly-active segment for small and mid-sized companies offers particularly attractive opportunities.
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A headline theme across private markets over the past two years, driven by inflationary and interest rate pressures, has been the slowdown in deal and exit activity.
At the same time, there has been significant attention on the rise in secondaries as an investment theme. The secondaries market recorded $160bn in transaction volume globally in 2024, a new annual record, and is positioned strongly for the coming year.
This reflects the continuation of a longer-term trend: as the private equity market matures and expands, the secondary market has similarly continued to grow and evolve. Demand for liquidity from private equity investors has only increased, driven by the notable decrease in exits and distributions during the past couple of years.
Coinciding with the growth of secondaries has been that of continuation fund transactions – otherwise referred to as ‘GP-led secondaries’ – that enable existing managers to extend the hold period of their highest-quality assets, backed by new capital. Continuation funds have become a key growth driver within the secondary market, accounting for 45-50% of deal volumes over the past several years (see chart).
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 realized.
Continuation opportunities in the lower-mid-market
GP-led secondaries involve a fund manager (general partner, or GP) structuring a new fund vehicle to buy a portfolio company, or small selection of companies, from an existing fund. They enable GPs to offer liquidity to investors (limited partners, or LPs) in the existing fund, while also providing the opportunity to extend the hold period and realise the full growth potential of their most-prized companies.
Key to the thesis for these transactions is bringing in new capital to fuel the next stage of growth for the underlying company, which might not otherwise be possible within the constraints of the existing fund structure. You can read more about the differentiated value proposition and risk-return potential of continuation funds for investors targeting this space by reading our previous InFocus paper.
In this article we will focus on the compelling GP-led secondaries opportunities in the lower mid-market, covering continuation transactions for companies in small and mid-sized buyout funds. We believe this space is particularly attractive due to its combination of a very broad investment universe, comparatively favourable entry valuations, and strong potential for transformational growth supported by a wide array of future exit options.
Large and diverse investment universe
The bulk of GP-led secondary opportunities are concentrated in the lower mid-market. This reflects the reality of the wider private equity universe; according to figures from Preqin, there are 10x more GPs and funds with either less than €500 million (small cap) or €500 million to €2 billion (mid-market) in capital to invest, compared to those with more than €2 billion (large cap).
The larger quantum of funds, and underlying portfolio companies, in the lower-mid-market corresponds to the proportion of continuation fund opportunities arising from them. To illustrate this, more than two-thirds of potential transactions evaluated by Schroders Capital over the past two years have related to underlying companies with enterprise values of less than $750 million (~€720 million – see chart).
Continuation fund deal flow is concentrated in the lower end of the market
Past performance is not a guide to future performance and may not be repeated. Source: Schroders Capital, 2024. 1. Represents total CV size (funded + unfunded) for single asset and multi-asset GP-led opportunities evaluated by Schroders Capital over the past two years. 2. Represents the enterprise value of single asset GP-led opportunities evaluated by Schroders Capital over the past two years.
Of course, this larger deal funnel, coupled with the less well-known nature of the underlying companies, makes sourcing transactions in this space more challenging. Notably, continuation fund opportunities for these companies often do not reach the broader market and are marketed selectively to secondary investors with whom the fund manager already has a relationship.
As a result, secondary investors that specialise in the lower mid-market and that also have broader platforms with primary or co-investment capabilities to invest alongside lower mid-market buyout managers, have a significant advantage in sourcing transactions. As such, they can be much more selective.
Attractive transaction economics
Beyond this there are several fundamental attributes of lower mid-market continuation fund deals that make them particularly attractive. These include that investments are typically executed at lower valuation multiples and with lower levels of leverage, theoretically providing more headroom to grow and reduced financing risk.
Secondary market industry data up to the end of 2023 indicates that approximately 60% of continuation fund deals completed by small or mid-sized secondaries funds (defined as those with less than $5 billion in capital raised) were completed at entry valuations of less than 13x EBITDA, with up to 30% completed at less than 11x EBITDA.
In contrast, more than half (56%) of all transactions completed by large-cap secondaries funds with more than $5 billion in capital were valued at more than 13x EBITDA, with none valued less than 11x EBITDA.
These findings align with data related to direct small-mid buyouts, which as of the end of Q3 2024 benefitted from a 6x EV/EBITDA valuation discount compared to large-cap buyouts.
Lower buyout multiples in 2024 as fundraising slows
Past performance is not a guide to future performance. Source: Capital IQ, Global M&A Outlook 2024, Robert W. Baird & Co., Schroders Capital, 2024. Note: North America and Europe M&A. Completed deals. LTM through 30 September 2024.
We anticipate GP-led transactions will continue to represent a particularly compelling opportunity in the current exit-stressed market. Furthermore, these transactions solve key limitations of private funds concerning investment thresholds or lifespan, thus the GP-led market is expected to continue to grow, even as deal and exit activity fully recovers.
Potential for transformative growth
Moderate pricing and leverage in smaller and mid-sized deals sharpen the focus on operational value creation – again, in line with wider buyout dynamics. We believe this is where the key attraction of investing in the lower mid-market comes to the fore; businesses in this space have greater potential for transformative growth.
Put simply, there are inevitably more value-creation levers for companies that are smaller in size compared to larger companies that have already scaled, or that are already well diversified across segments. These levers range from governance enhancements, to expanding into new geographies, product areas or sectors, or even consolidation via strategic add-on M&A deals.
Moreover, companies sold to continuation funds have already been under private equity ownership with the same GP and so will invariably have benefitted from some of these improvements and have established growth plans in place.
The rationale for a well-positioned continuation fund deal often involves new follow-on capital to enable the next phase of growth for the business. This may not be possible in the existing fund either because individual asset investment thresholds have been reached, the fund has run out of capital to deploy, or the fund is at the end of its lifespan.
Wider range of exit routes
Small and mid-market buyout companies also have a wider array of exit options, including sponsor-to-sponsor sales to large-cap private equity funds, which currently have a substantial war chest of capital to deploy, or sales to strategic corporate buyers. This means there are multiple avenues for GPs to realise the value of the growth achieved during the life of the investment, irrespective of wider market conditions.
In the case of large-cap deals, by contrast, there are more limited options to sell upstream to other private equity funds or corporates, meaning GPs may need to be more reliant on public markets to exit their companies.
This underlines why, based on a sample of 100 historical GP-led transactions assessed by Schroders Capital, small and mid-market continuation fund transactions are generally underwritten to higher target returns by their sponsoring GP. The target return multiple (TVPI) for continuation deals relating to companies with an enterprise value of less than $800 million (~€750 million) was 2.9x, compared to 2.4x for larger-cap deals.
A market that will continue to grow
We anticipate GP-led transactions will continue to represent a particularly compelling opportunity in the current exit-stressed market. Furthermore, these transactions solve key limitations of private funds concerning investment thresholds or lifespan, thus the GP-led market is expected to continue to grow, even as deal and exit activity fully recovers.
Enormous market potential of continuation funds
Source: Jefferies, Evercore, Lazard, Greenhill, Credit Suisse, Schroders Capital, 2024. The views shared are those of Schroders Capital and may not be verified.
With market growth and evolution will inevitably come continued innovation. However, what remains unchanged, much like the dynamics within the wider private equity market, are the fundamental drivers of value and performance. This in turn drives our conviction that continuation funds in the lower mid-market, characterised by attractive competitive dynamics, transaction economics, and greater focus on operational value creation, will continue to provide particularly compelling opportunities.
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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