This article was first published in the Financial Times.
We are currently experiencing one of the worst liquidity crunch periods in investment history post the global financial crisis.
The rapid rise of interest rates and the velocity of the increases over the last two years has resulted in an unprecedented shift of capital flow from long term growth allocation to short term lower risk interest bearing assets.
Deal values, exit values, funds closed count, number of new funds launched, distributions paid to investors, value of aging unexited assets – it all indicates the same thing: The market has stalled, GPs (General Partner and Manager of a Fund) have pressed the pause button and LPs (Limited Partners – investors in a Fund) are desperate for cash and any return of capital.
The area that has benefitted from these challenges is the secondaries market, which has seen a surge in capital raised in 2023 and with the liquidity crunch continuing to plague the industry, it is expected that the increase in secondary transactions will continue throughout 2024.
The Bain & Co Private Equity Report 2023 indicates secondary funds raised 92% more capital in 2023 than in 2022 and the emergence of GP led exits through Continuation Funds was one of the most popular ways to capture the rise of secondaries market.
A Continuation Fund is a type of GP-led secondaries process which involves the GP selling one or more of its existing fund assets to a new structure (i.e. the Continuation Fund), mainly funded through secondary investors, but also offering the option for existing LPs to “roll” and re-invest their holdings into the Continuation Fund managed by the same GP.
Continued Evolution
Continuation Funds are not new and the structure has evolved over the years from originally being used as a way for GPs to move struggling assets out of Funds and to allow them more time to turn their performance around, to becoming a popular structure for GPs to retain exposure to their “trophy” assets, to limit the negative impact of forced exits in fixed term funds and to allow Investors to double down on their winners.
In the last two years, the purpose of Continuation Funds has shifted again, now as an alternative exit strategy to create liquidity for existing LPs.
It is estimated that nearly 10% of all distributions made to LPs in 2023 came from Continuation Fund transactions and the surge in the proportion of LPs who elect to cash-out is a clear indication of the demand for cash and return of capital which is the driving force behind the popularity of Continuation Funds to generate liquidity for LPs.
Continuation Funds are often seen as win-win exit transactions where all parties benefit from the transaction. Some of the key benefits and advantages include:
- Provides exit liquidity for LPs in existing Funds
- Enables GPs to realise performance and crystalise carried interest
- Often high performing assets deliver higher returns compared to traditional buy-out Funds
- Shorter payback periods
- Cost drag is typically lower than normal funds
- Provides continuity and stability for Portfolio Companies
- Allows additional time to create and execute plans without distractions normally accompanied with other exit strategies
During 2023, the model of GP-led Continuation Funds was also used across a variety of asset classes, spreading to the impact investing arena, with both Japan based buy-out firm, J-Star and Swedish based Summa Equity using Continuation Funds involving waste treatment and recycling assets.
More recently the Private Credit sector has seen the usefulness in Continuation Funds, leveraging the GP led exit model developed in the private equity sector. As the investor requirement for timely return of capital continues and traditional exit strategies remain tapered across the investment industry, we expect to see the rise in use of Continuation Funds across a variety of new asset classes in coming years.
First among equals
For GPs considering using the Continuation Fund model, selecting the correct domiciliation for the structure is often an important step that shouldn’t be overlooked. Choosing a jurisdiction with regulatory certainty and flexibility that are tax neutral, cost effective and enable speed to market is crucial.
International financial centres, such as Guernsey, offer all the above, as well as a strong service provider community (Lawyers, Auditors, Banks, Fund Administrators etc.) that can support the establishment and ongoing operation of a Continuation Fund. Guernsey as a jurisdiction offers strong protection of investor rights and can support marketing into most jurisdictions.
For single asset Continuation Funds there is also a lighter regulatory regime, which can further support speed to market and keep costs as low.
Despite interest rates certainty and outlook improving, the demand for liquidity from LPs continue and the growth of the secondaries market and the use of Continuation Funds as a legitimate exit route for GPs is expected to continue to rise in popularity in 2024.
