Are LPs missing the continuation fund boat?

Investors in private equity funds that shun GP-led processes could be missing out on significant upside, according to research by Upwelling Capital Group.

A study by the consultancy argued how LPs that systematically avoid rolling over their exposure to continuation funds are incurring a tangible opportunity cost of around 8 percent per vintage year. Compounded, the cumulative opportunity cost over a 10-year period “could be in excess of 15 percent of total cash-on-cash returns,” Upwelling notes.

“For every year an LP forgoes rolling into a [continuation vehicle], they give up an extra 15 percent-plus gain over the long run,” Upwelling founder Joncarlo Mark told affiliate publication Private Equity International in late 2022.

Research from Lazard showed that in H1 2022, 90 percent of LPs chose to sell their exposure when faced with a continuation fund opportunity from one of their GPs.

The advent of continuation funds “fundamentally changes the way an LP has to operate,” Mark said. “They no longer can just make LP commitments and sit on their hands. That’s the biggest issue here – it’s forcing them to be responsive in a different way with their [general] partners.”

Continuation funds and GP-led processes have attracted attention over the past year from the US Securities and Exchange Commission, which has highlighted areas for potential conflicts of interest, as well as suggested best practices for running such processes in a fair manner for investors.

• Upwelling’s research assumed the following:A $1 billion per year investment pace;
• A median performance of the entire portfolio being based on the TVPI of 2012-vintage buyout funds;
• Around 5 percent of an LP’s portfolio being offered up for continuation vehicles, based on separate figures from Bain & Co and Lazard on 2021’s total buyout volume versus continuation fund transactions;
• A weighted average performance for continuation vehicles of 4.2x for single-asset deals, 3.2x for multi-asset deals where part of the fund has been involved, and a 2.6x for multi-asset deals involving all the assets in a fund (based on data compiled by Hamilton Lane in 2021 on continuation fund performance);
• For LPs that sold when faced with continuation fund opportunities, proceeds were reinvested immediately on a primary basis with median returns;
• Fifteen percent carried interest paid to the GP at the end of year 10;
• LPs are only participating in GP-led opportunities offered by their existing sponsors.

In Upwelling’s study, the delta for an LP participating in continuation funds versus selling was $153 million. Compounded over one decade, that leads to the 15 percent-plus difference, according to Mark.

LPs need to evolve

The short amount of time – sometimes 20 business days – by which an LP typically must respond to a GP running a continuation fund process, has led to some frustration from investors and is an area the SEC has stated it is looking into.

“When that email pops into your inbox, it’s the last thing you want to see,” the former head of private equity at a major US public pension told affiliate title Secondaries Investor in July 2022. “The default option is often an automatic sell, which seems like a pretty short fuse to me.”

“LPs are being asked to be more sophisticated today in the way they manage their programs”

Joncarlo Mark
Upwelling Capital Group

Upwelling recommends that LPs and GPs strengthen their communication over potential continuation fund processes. LPs should be proactive in finding out from their GPs whether they are considering running a continuation fund process on one of their vehicles, and be “more active” in monitoring their managers and their underlying portfolios, while GPs should engage in regular dialog to mitigate surprises. Doing this will provide sufficient time for a thorough underwriting process of these opportunities, Upwelling notes.

The consultant acknowledges that doing this will require a change to LPs’ investment policies, processes and staffing. Investment policies should allow LPs to be “nimble,” such as delegating authority to commit to continuation funds. It also suggests LPs should clarify basic terms that need to be met if they are to rollover their exposure into a continuation fund, such as the minimum percentage of GP capital rolled, management fees, tiered carried interest and co-investment rights.

“It is a challenge if your plan is designed to make fund commitments and that’s it, but it’s reflective of the evolution of the asset class,” Mark said. “LPs are being asked to be more sophisticated today in the way they manage their programs.”