Once used to sell off zombie funds or badly underperforming assets, a growing number of continuation funds are being launched around high-performing trophy assets that aren’t currently fetching their proper valuation. Unsurprisingly, while GPs applaud the strategy, LPs are more reserved due to potential conflicts.
“The flavor of continuation funds has changed,” says Raudel Yanez, a managing director at Greenwich, Conn.-based Kline Hill Partners, a secondary firm which has led three technology-related continuation funds this year. “Now, managers are inclined to hold onto their prized trophy assets for a few more years.”
Yanez says continuation funds are an increasingly popular strategy to take in a dealmaking climate of depressed valuations and a continued valuations standoff between buyers and sellers.
“With additional time and sometimes new capital to fund growth initiatives, these companies become even more valuable to stakeholders,” Yanez says. “In a way, continuation funds allow managers to not leave value on the table by selling too early.”
Data from investment bank Jeffries show GP-led secondary volume worldwide in the first half of 2023 at $18 billion, down 25 percent from the record raised over the same period last year. Most secondary transactions are continuation funds. And that pace appears to have picked up in the second half of 2023.
Lingering skepticism by LPs does remain, however, largely because the buyer of the asset with a continuation fund is also the seller of the asset.
“It’s perfectly natural for LPs to be skeptical of a transaction between affiliated parties as it inherently carries with it the potential for conflicts,” says Goodwin partner Robert Emerson, co-head of the law firm’s secondaries practice.
But as these vehicles mature, LPs’ concerns are being addressed. It’s now commonplace for LPs to obtain fairness opinions and most deals now include “status quo” clauses that guarantee LPs can roll over into the new vehicle with the same fees and carry.
In most current transactions, LPs are given the option to cash out or roll over their investments in the new vehicles.
Technology companies, in particular, are getting folded into continuation funds because of their abilities to scale quickly, investors’ familiarity with the sector and a clear path to increased value.
Placement agent Asante Capital Group says 42 percent of its recent secondary activity involved technology companies, far and away its busiest secondary sector.
“Technology is a very dominant sector,” says Asante’s head of secondaries Yaron Zafir. “Technology companies are particularly suitable for this vehicle.”
Zafir says secondaries are maturing into a mainstream vehicle with staying power.
“They had a stigma attached to them,” Zafir says. “That has completely turned on its head.”
Bigger PE shops are taking notice and jumping into the game, raising cash beyond initial targets.
In September, Goldman Sachs Asset Management raised $14.2 billion, $2.2 billion over its target, for its newest secondary fund, Vintage IX.
Two tech-centric continuation funds were launched this month, both involving Yanez’s middle market shop Kline Hill. Kline Hill partnered with Lexington Partners to create a new fund for a promising BV Investment Partners portfolio company Right Networks.
Right Networks is a growing cloud-based software company used by 10,000 accounting firms and 60,000 businesses, according to BV. BV’s original fund containing Right Networks was expiring and BV wasn’t ready to part with the promising company it acquired in 2017 at current valuations.
So Lexington, BV, Kline Hill, Stepstone Group and Apogem Capital created the single-asset fund.
An increasing number of continuation funds are now adding multiple assets.
Earlier this year, giant software player Insight Partners with HarbourVest Partners and Lexington Partners closed a $1.3 billion continuation fund for software companies in six of Insight’s funds.
Kline Hill also partnered with ABS Capital earlier this month to move two tech companies, LabConnect and Viventium, to a new fund the two PE firms created along with Five Arrows.
Kline Hill earlier this year also partnered in a continuation fund with Presidio Investors, its first experience with the vehicle. Kline Hill and Presidio launched a fund for EleVATE, a San Diego semiconductor company Presidio acquired in 2018.
“With this transaction, we are able to have a longer-term view for the growth of the business,” EleVATE chief executive David Kenyon says.
But LPs will still keep a sharp eye on this trend. The Institutional Limited Partners Association issued guidelines on these types of funds in May. Since continuation funds are becoming so prevalent, ILPA advises LPs to develop internal processes to handle continuation funds.
“As continuation fund transactions increase in prevalence, greater transparency and consistency in these deals will be critical to their efficiency and quality of execution,” ILPA concluded.
