CFOs who have a good relationship with the private equity fund that supports their company might consider suggesting a general partner-led continuation fund to keep the relationship going if the original investment life is nearing its end, deal pros indicate. 

Many PE investments operate with a five- or 10-year time horizon, at the end of which the fund GP looks for an exit for both the fund and the limited partners who’ve invested in it. Often that means the sale of the portfolio company to another company in an M&A deal or another PE firm. Or the company could go public.

But a sale to another firm comes with risks, especially if the operating company is used to working with an equity partner that’s taken a long-term perspective and helped it grow and scale in a sustainable way. A new partner might not be as compatible, especially if it feels the company is worth more by squeezing it as much as possible, Michael Tose, co-founder and partner of private equity firm Columna Capital, said in a Dechert LLP webcast.  

“In some cases, that new sponsor will rely more heavily on leverage as a driver of return,” he said.

An alternative that a growing number of PE firms are looking at is a GP-led continuation fund, in which the GP launches a separate fund, capitalized by existing and maybe some new investors, to buy the investment from the other fund. The goal is to infuse new life into the investment and take the portfolio company to a new level of growth, if the PE firm believes there’s upside that can be unlocked with a new investment structure.

“The sponsor really needs to have a credible rationale for this type of transaction,” said Tose. “You have to have a clear plan for further value creation over the next cycle of the asset in question. If you have that rationale and you have the willingness or desire on the part of the management team of the portfolio to maintain an association with the sponsor, this really gives you a very strong framework within which to start the dialogue with investors.”

Growing interest

The finance technique has taken off in recent years. There was a record $130 billion in secondary transactions created last year, compared to $60 billion in 2020, said David Lee, managing director of the transactions opinions group at Duff & Phelps, a Kroll company. Of the $130 billion, $70 billion was GP-led recapitalization activity, a more than 150% increase over 2020.

“It’s been driven primarily by high levels of available dry powder and pent-up buyer demand,” said Lee. “These GP-led secondaries continue to grow their overall share of the secondaries market, and in 2021, represented more than 50% of total secondaries volume. People refer to this as a shift to a new normal, where GP-led volume is now on par with, and will most likely exceed, limited partner-led transactions going forward.”

Proactive stance 

The decision to create a continuation fund is the general partner’s to make in consultation with limited partners, but if the management team of a portfolio company believes it’s thriving in part because of the strong partnership with the sponsor, it can make sense to explore whether a continuation fund could keep the relationship going. 

“If you’re in a situation where management [of the portfolio company] is looking for a transition, in some cases, but also looking for stability within the business and the capital structure, they will be highly supportive of a GP-led solution rather a traditional M&A route, where clearly you have no idea who you will end up with from a management perspective,” said Tose. 

From the GP’s perspective, launching a separate fund to buy the investment can make sense if the relationship with the portfolio company has been a good one.

“You may just see highly visible growth, strong alignment with management and feel now is not the right time to sell the business,” he said. “It may be the constraints of the fund structure in which the asset is held is coming to its end and you need to find a solution, so I think that is a highly important motivation for a GP to look for a GP-led continuation solution.”

Involved process

Even though the deal involves existing investors, structuring a new fund can take six months to a year, so coming to agreement on whether to do it or not should start with that timeline in mind. 

“A secondary process creates lots of demands on the schedules of the deal team and management of the portfolio companies,” said Lee.

One reason for the lengthy process is price discovery. The deal has to be priced with the same considerations about transparency and fairness as any other transaction, so deciding how to price and allowing time for the discovery process to play out must be factored in.

“Engaging with us earlier on gives us enough runway to complete our due diligence and be additive to the process,” said Lee, who oversees a team of valuation specialists at Duff & Phelps, which is part of Kroll, who are brought in as a third-party to render a fairness opinion. 

Having a third-party firm render a price opinion is just one way to do it. An auction is another. There are also variations, including by breaking off a minority piece and selling that, the price for which can then be used to set the price for the majority stake for sale in an auction setting or in a bilateral negotiation with the buyer, in this case the new fund, although that kind of deal can raise conflict issue that must be mitigated.

In one recent transaction, Lee’s team was involved in a dual-track process, and rendered a fairness opinion to a U.S. blue chip sponsor in connection with a secondary transaction that also involved the sale of a partial stake in a $4 billion interest to a third-party sponsor.

“The sponsor started off by selling about $1.5 billion of the $4 billion to another new third-party brand name sponsor and the remaining $2.5 billion is being syndicated in the continuation fund at the price that was paid by the third-party sponsor,” said Lee. “What’s interesting in this deal, because it’s so large, is if the remaining $2.5 billion can’t be fully syndicated in the continuation fund, the sponsor would consider taking up that difference as a direct investment in its next flagship fund.”

Given the complexity of the deals, which need time for parties to work out pricing and other matters, given their existing relationships, the sooner conversations can start about whether the deals make sense the better. 

“There are challenges and differences in each one [of the price-discovery models you use], so it’s important to really have the right support, right plan and right timetable to be able to effect either route,” said Tose.