Clayton Dubilier & Rice was one of the latest firms to eschew the constraints of the traditional 10-year fund lifecycle when it shifted 61% of its stake in British vehicle glass repair group Belron into a new $4 billion vehicle in December.
The remaining stake was sold to investors including GIC and BlackRock in a deal that valued Belron—originally bought at a valuation of €3 billion (about $3.4 billion today) in 2018 via CD&R Fund X—at €21 billion.
CD&R is not alone in seeing the value of holding on for longer. The practice of rolling portfolio assets into so-called continuation funds has been the main feature of a GP-led secondaries surge that has in turn been a major driver behind secondaries activity as a whole. The trend, which offers GPs a lot more flexibility on hold periods, is unlikely to reverse any time soon.
Historically, continuation funds were a means of moving unrealized portfolio investments out of a fund that was at the end of its life span. Often it implied that the vehicle was in some kind of distress and unable to return capital to LPs. This is no longer the case. Today you’re more likely to see continuation funds being used by healthy vehicles as a means of extracting more value from their best performing assets.
“The strategy is increasingly being viewed by both general partners and limited partners as a viable exit path for portfolio companies—just as if a general partner takes a company public, or exits through a trade sale or a secondary buyout,” said Dennis Scharf, a managing director on the secondary investment team of asset manager Hamilton Lane.
Continuation funds are just one type of GP-led secondary deal. Others include fund restructurings, GP-led tender offers, portfolio strip sales, and stapled transactions. However, continuation funds have become the most common structure for sponsor-led secondary deals.
In 2021, continuation funds accounted for 84% of GP-led transactions, which totaled $68 billion, according to data from investment bank and secondaries adviser Jefferies. Single-asset continuation vehicles represented nearly half of GP-led volume during the same period, up from 27% in 2019, data compiled by the firm shows.
Total secondary deal volume stood at $132 billion last year, breaking the record of $88 billion set in 2019. It’s the second consecutive year that GP-led deal volume surpassed traditional LP transactions.
Andy Nick, a managing director at Jefferies, noted that when the secondaries market re-opened in Q3 2020—following the initial onset of the pandemic—the majority of secondary transactions were GP-led deals that had involved single companies buoyed by macro tailwinds.
Moreover, buyers were less comfortable with performing due diligence on a broad portfolio of LP interests as they didn’t yet know the impacts of the pandemic. Multi-asset transactions were also less popular given the difficulty of navigating each company’s risks.
“When sponsors came to investors with the idea of doing single-asset continuation funds for their best companies, that really resonated with them,” he added.
In addition to the high-profile CD&R deal, a slew of well-known PE houses have raised continuation funds in recent months.
Thompson Street Capital Partners closed its first-time continuation vehicle in December, taking on two technology investments that were held in its older-vintage funds: business communications provider BCM One and Revenue Management Solutions, a processor of healthcare remittance. In a statement by the firm, they were described as “two of the best-performing portfolio companies in TSCP’s 20-year history.”
Big asset managers including Platinum Equity, Providence Strategic Growth, Oak Hill Capital and First Reserve have reportedly all announced or closed new continuation funds for select portfolio companies in recent months, as have boutique investors such as Lime Rock Partners, Metalmark Capital and CREO Capital Partners.
The strategy is being used not only by buyout funds, but also by growth equity investors and venture capitalists. California-based Upfront Ventures has launched its Upfront Continuation Fund I, which collected $176.5 million in January, according to a filing with the SEC.
The wider adoption of continuation funds comes at a time when many GPs are looking for new ways to align conflicting goals of holding onto trophy assets longer and managing liquidity targets across existing funds.
“Providing liquidity options through continuation funds helps GPs increase the ratio of distributions over paid-in capital on their existing funds, which can be helpful for fundraising,” Paul Lanna, a partner at Coller Capital, explained.
At the same time, fund managers are coming back to the market to raise ever-larger funds at ever-shorter intervals. Nigel Dawn, head of the private capital advisory group at Evercore, noted that almost every LP his firm speaks to has a lot more investment opportunities with existing managers this year than capital available.
“It’s almost universal. They have to be very selective about who they ‘re-up’ to and where they spend the capital right now,” Dawn said.
The structure is far from perfect. Some LPs complain about short decision-making time frames and the additional work that comes with completing due diligence on the assets held in a continuation fund.
But it hasn’t stopped the strategy from gaining traction. “Most investors we have talked to see it as a win-win, almost like a natural evolution of the private equity market, like a natural asset class extension, which explains the acceleration of this market now,” Dawn said.
Moreover, business owners and management teams have shown their fondness for continuation funds. Some portfolio companies even voluntarily offer to be selected for a continuation fund as an alternative to a secondary buyout.
“Traditional exit routes such as selling to another PE sponsor means the management team will have to adapt to a new board of directors, while in a strategic sale, executives face the risk of losing their jobs due to redundancy,” Nick said. “If it’s an IPO, managers ultimately get some liquidity, but are likely subject to a lock-up period and the related potential stock price volatility.”
Contrast that with a continuation fund where the existing management team can get liquidity from the transaction just as they do in a sponsor-to-sponsor sale.
“The management team can typically get some proceeds from the sale by cashing out a portion of their equity, usually up to 50%, which is similar to what we would see if the company was sold to another sponsor,” Nick noted. “They get some liquidity from an exit event, and don’t have to worry about the potential fit with a new sponsor.”
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