The rise of continuation funds in private equity markets could be an opportunity for portfolio companies to stick with their investors for longer periods of time, a good deal for those with ample sponsor support.
Like special purpose acquisition companies (SPACs), which have been around for decades but only recently gained popularity, continuation funds have been an option for equity sponsors to breathe new life into their portfolio companies.
But, also like SPACs, the funds, until recently, were seen as something of a negative — a way for sponsors with a troubled company or portfolio to attract new money in the hope of salvaging the investment.
But today the funds are sought after because they give sponsors who are coming to the end of a fund timeline and have limited partners seeking an exit a chance to drive additional value creation in an already successful investment.
“The stigma is gone around these kinds of transactions," Hani El Khoury, an investment principal with Coller Capital, said in PitchBook. "It's more of a case of general partners catching up with this market and really realizing the value that the secondary market can bring to the portfolio, to their investors, and to themselves."
“There are good reasons why GPs like them,” Patrick Kocsi, head of U.S. co-investment at Ardian, said in a Dechert LLP webcast. “The sponsor believes that it still has some opportunity [with their portfolio company] but they’re running into a timeline and so this is an elegant way for them to extend the timeline . . . and get more capital into the business.”
The funds have ballooned in recent years, from $26.8 billion in 2017 to $96.6 billion last year, according to data reported by PitchBook. Investments totaling almost $15 billion were in the pipeline in just the first few weeks of 2021.
In a typical scenario, a sponsor with a successful portfolio company or companies in which the initial investment fund is nearing 10 years old will launch a fund as a vehicle to buy out the old fund to extend the investment’s life. The new fund gives existing limited partners the chance to exit and extract their return or stay in for more.
“GPs can contribute some of their star assets, some of their best portfolio companies, into these continuation vehicles,” said Kocsi, whose company makes co-investments in private equity funds. “They could probably sell them in an outright sale, but they believe there’s more value creation to be had, and in the future they want to monetize that in some way.”
One reason a sponsor might want to extend its investment is a portfolio company’s fast growth. If the company has grown to a size where it needs more money to pursue organic or inorganic growth than is available in the original investment reserve, the continuation fund can solve that problem.
Kosci said he was evaluating a deal in which the vintage investment was seven years old, but the sponsor believes the portfolio company has untapped potential. If he goes ahead with the deal, it will be the latest in a handful his company has made in recent years in the U.S. and Europe.
“If you would have asked me three years ago what’s a continuation vehicle, I would have given you a blank stare,” he said.
The decision to bring more money into an investment is the sponsor’s to make, but it would make sense for CFOs of portfolio companies to raise continuation funds as an option with their sponsor if they have growth plans requiring new capital and they like working with, and get a lot of support from, their PE investor.
This is especially the case if they rely extensively on the expertise the sponsor brings to the relationship. It’s not unusual for sponsors to have on staff people who specialize in controls, pricing, product commercialization and other functional areas and also have access to legal, accounting, and other types of external help.
For a startup, these kinds of resources can be invaluable and they’re often part of the reasoning behind the investment deal in the first place.
"If we can continue as we have and raise private equity and debt in the levels we need, we'll continue to keep doing that" rather than pursue going public, Tipalti CFO Sarah Spoja has said.
She credited the sponsor’s resources as one of the chief benefits of staying private even though an IPO would bring the payments automation company a much broader base of investors.
"I think of public equity as just another form of capital raising," she said.
On the investment side, co-investors would need to give a continuation fund offering the same scrutiny they would give any opportunity, even though the sponsor and the portfolio company or companies have a track record.
Kocsi said he wants to see the sponsor inject new capital into the fund, not just put the fund out and capitalize it with money from partners.
“That’s alignment that I like,” he said. “I like that a lot. I look for that. Is that in every deal? No. So, every time we see one, we have to up our game and make absolutely sure we feel on a net [investment return] and net multiple-investor capital [basis] in the future, we think the risk return is there.”