The business model of the private equity industry 

The business model of the private equity industry is to acquire a (majority) stake in a portfolio of private companies through a fund managed by the private equity firm. The acquisition is made with cash that investors put into the fund often in combination with third party loans. The private equity firm puts in hard work to grow or rebuild the portfolio companies. The funds typically have a ten-year term whereby investors have their capital “locked in”. They will only get their cash back when the fund sells, or “exits from” as the industry calls it, the portfolio companies. Exits usually take place after some 5-10 years; growing or rebuilding a company simply takes time. Exits must be carefully planned to identify the right moment and buyer to secure the best transaction price. Profits are split between the private equity firm and the investors in the fund, usually in a 20/80 proportion.

Answering to a slow exit environment or cherishing trophy assets

Most private equity funds have struggled with their exits in recent years. Due to increased financing cost buyers are no longer willing to pay the prices of 2018-2022 period, while sellers were not ready to swallow losses. A substantial price gap has opened.  

Private equity firms may therefore prefer not to sell but rather to hold on to their assets awaiting a better moment to exit. As such, the private equity industry struggles to return cash to investors, while investors push for liquidity.

In the hunt for liquidity investors may decide to sell their interest in the fund to third party buyers, such sale being referred to as an “LP led secondary”. If such transactions are initiated by the private equity firm, they are referred to as “GP led secondaries”. In todays’ market such transactions often occur at a steep discount which may make them difficult to swallow.

A continuation fund is a manifestation of a GP led secondary and an answer to a challenging exit environment, but also a tool to hold on to promising assets (“Trophy Assets”) while the fund comes to term.

A continuation fund, everybody may win!

In a continuation fund deal, the private equity firm launches a new fund: the continuation fund. The continuation fund acquires investments from the original fund. Investors in that selling fund have the choice to either get their cash back and step out or remain invested in the underlying portfolio through the continuation fund.

The transition secures that investors in need of cash can get that liquidity. The investors that remain invested (referred to as ‘rollover investors’) can benefit from continued value creation of the portfolio companies. The private equity firm also benefits, as it can continue to manage the portfolio companies, earn management fees and share in the upside of the eventual exit.

Continued management is also beneficial for the rollover investors. The private equity firm knows the portfolio companies inside out and can continue executing its value creation strategy, while a new manager would have to go through a learning and familiarization curve.  

A continuation fund - working towards a successful deal

Continuation fund transactions are complex and full of conflicts-of-interest, not in the least because the private equity firm is the manager of both the selling and continuation fund. Investor involvement at an early stage and transparent communications are therefore key for a successful continuation deal. Setting a fair transaction price for the transfer of the investments is paramount. A commonly used method is to organize a competitive bidding process for an interest in the continuation fund. Both new investors and existing investors can participate in that process through which they indirectly price the underlying portfolio. This helps to avoid concerns around pricing that would certainly arise if the private equity firm itself would set the price. A continuation fund is a “big ask” from rollover investors; they forego liquidity based on the promise of a better exit in the future and the transaction is costly in terms of advisory fees. For this reason, rollover investors require the private equity firm to align with their interests. In that context they require a substantial investment commitment in the continuation fund from the private equity firm and that the private equity firm only shares progressively in the exit proceeds if substantial gains are made. The private equity firm should “put its money where its mouth is”.

Summary

Continuation fund transactions are an answer to a difficult exit market and accommodate the continued management of trophy assets. Continuation fund transactions are complex and only successful if they are based on transparency, a careful bidding process, and efficient alignment of the interests of rollover investors and the private equity firm.

And that is another private equity buzzword demystified!

This article was first published by Luxtimes.lu.