In the realm of private equity (PE), methods for exiting investments have transformed significantly. The reliance on straightforward initial public offerings (IPOs) or quick mergers and acquisitions (M&A) as primary exit routes has diminished. A novel approach known as continuation funds is now reshaping the landscape of investment exits.
As financial conditions shift towards higher interest rates, the favorable exit opportunities that once existed have decreased. According to recent findings from McKinsey, the average holding period for buyout investments has increased from 5.7 years to 6.7 years over the past two decades. Additionally, the backlog of exits has reached unprecedented levels since 2005.
The rise of continuation funds
Continuation funds have emerged as a solution to the evolving challenges faced by private equity firms. These vehicles enable a PE firm to transfer one or more assets from an aging fund into a newly created structure, often managed by the same general partners (GPs). This arrangement provides existing limited partners (LPs) the option to either exit their investments or roll them over into the new fund.
In one recent year, the number of continuation funds surged by 12.9%, with 96 vehicles recorded, now representing 14% of all PE exits. This trend signifies a shift from a niche strategy to a more mainstream approach within the private equity space. A notable example includes the $3 billion deal involving Alterra Mountain Company, which underscores the increasing scale of these funds. Analysts predict that continuation funds could account for up to 20% of all PE exits in the near future, driven by a maturing secondary market and challenging exit conditions.
Factors driving the change
Several key factors contribute to the rising popularity of continuation funds. Increasing financing costs have made leveraged buyouts more challenging, resulting in a widening gap between bids and asks in M&A transactions. Continuation funds offer managers the opportunity to retain high-conviction assets while providing liquidity options for investors.
Another critical element is the looming maturity wall facing private equity. Over half of PE funds are now over six years old, with a significant number set Continuation funds allow firms to extend their value creation efforts without resorting to forced asset sales.
Benefits and performance of continuation funds
The flexibility offered by continuation funds aligns well with investor demands. Limited partners can choose to cash out for immediate liquidity or reinvest for potential future gains. New investors can benefit from established, high-performing assets that come with a reduced risk profile. Recent studies indicate that continuation funds exhibit a loss ratio of 9%, significantly lower than the 19% seen in traditional buyouts, thus providing better risk-adjusted returns.
Proponents argue that these structures serve the interests of all stakeholders involved. GPs have the opportunity to continue managing valuable assets, generating ongoing management fees and carried interest. Existing LPs benefit from liquidity options without sacrificing potential upside, while new investors gain access to assets with clearer return paths.
Performance metrics
Data supports the positive outlook for continuation funds. Research from Morgan Stanley reveals that top-performing continuation funds achieved a multiple-on-invested-capital (MOIC) of 1.8x, surpassing the 1.6x MOIC of comparable buyout funds. Specific industry examples, such as Lime Rock Partners’ strategic use of continuation structures in the energy sector, illustrate how managers can leverage these funds to navigate market fluctuations and enhance value creation.
Challenges and governance concerns
Despite the advantages, continuation funds face challenges. Governance and valuation issues can arise, particularly when GPs act as both sellers and buyers, leading to potential conflicts of interest. Critics express concerns about the transparency of such transactions, cautioning that without proper regulation, they may resemble circular financing structures.
As financial conditions shift towards higher interest rates, the favorable exit opportunities that once existed have decreased. According to recent findings from McKinsey, the average holding period for buyout investments has increased from 5.7 years to 6.7 years over the past two decades. Additionally, the backlog of exits has reached unprecedented levels since 2005.0
Regulatory landscape
As financial conditions shift towards higher interest rates, the favorable exit opportunities that once existed have decreased. According to recent findings from McKinsey, the average holding period for buyout investments has increased from 5.7 years to 6.7 years over the past two decades. Additionally, the backlog of exits has reached unprecedented levels since 2005.1
As financial conditions shift towards higher interest rates, the favorable exit opportunities that once existed have decreased. According to recent findings from McKinsey, the average holding period for buyout investments has increased from 5.7 years to 6.7 years over the past two decades. Additionally, the backlog of exits has reached unprecedented levels since 2005.2