After a surge of growth in recent years, a segment of the private equity secondaries market — called GP-led continuation funds — has been slowing down as investors become increasingly concerned about conflicts of interest and other issues.
In 2023, GP-led secondaries hit $51 billion, down from $68 billion in 2022 and are now less than half of the total secondaries market, according to a new report by Churchill Asset Management.
Nick Lawler, managing director and head of secondaries at Churchill, said investors have a “love-hate” relationship with the asset class. “Skeptics point to conflicts of interest in asset valuation, similar economic structures to equity co-investment programs but with fees or adverse selection,” he said in the report.
The GP-led market has exploded over the past five years, with more than half of the largest 100 private equity firms having executed a GP-led transaction, according to the Churchill report. And about 80 percent of the GP-led transactions are continuation vehicles, which involve a private equity firm recapitalizing the equity of one or more portfolio companies while maintaining control.
“Despite this tremendous success, there remains a healthy debate within the private equity community on its future,” said Lawler, author of the report.
Others are echoing these concerns. In a recent PitchBook webinar on trends in private equity, the organizers said there have been recent reports of continuation funds falling through and deals getting hung up. “Maybe those terms aren't as LP friendly as originally stated or the pricing on those deals hasn't been as attractive as the GP first thought when they started the process in the first place,” suggested PitchBook senior strategist Hilary Wiek.
Brian Hoen, director of industry affairs at the Institutional Limited Partners Association, said during the webinar that “over the past six, eight and 12 months or so, our members have been seeing continuation funds less frequently than they were in 2021, 2022 and 2023.” Last year ILPA issued guidance to the private equity community that said GPs should hire an independent advisor to ensure an arms-length transaction when taking assets out of one fund and putting it into a new continuation vehicle.
Churchill’s Lawler explained that GPs are inherently conflicted in continuation funds given they are both a buyer and a seller in the transaction.
The global financial crisis created the conditions for the asset to develop, according to PitchBook.
Continuation funds were “arguably born out of necessity, not opportunity, and viewed as a lifeline for assets that could not otherwise be sold,” Lawler acknowledged. But after 2018 GPs “began to recognize these innovative structures represented an attractive solution to extend the investment period for their highest performing assets” and became the fastest growing segment of the secondaries landscape. As a result, GPs began to turn to these vehicles for “assets they wanted to own longer, not had to own longer.”
Given the creativity and complexity these transactions require, the asset class was primarily reserved for the largest and most well-capitalized GPs in the market, Lawler added.
Another issue for investors is that these assets are marked at a conservative valuation when they are pulled out of the original fund, thus boosting the gain — and the carry — when they are sold in the second vehicle. A recent Whitehorse Liquidity Partners’ analysis of more than 1,000 transactions of assets sold by continuation funds found they were valued an average 28 percent higher than where the GP was valuing the business six months earlier.
Meanwhile, critics like Ludovic Phalippou, the Oxford University’s Said Business School finance professor, have argued that investors that opt into a continuation fund will likely pay a higher performance fee on these investments than they would have in the original structures. Private equity funds may not have been able to charge a performance fee if the other companies in the original fund did poorly and the average return was below the hurdle rate that private funds have to beat. “[Investors] are going to effectively pay a higher fee overall for these assets,” he told Institutional Investor last year.
ILPA’s Hoen said that “the first goal should be to maximize value for existing investors in the fund. The second goal should be that rolling limited partners should be no worse off than if the transaction had not occurred.”
The Securities and Exchange Commission’s private fund rule would have mandated that a registered private fund adviser obtain a fairness opinion or a valuation opinion when offering existing fund investors the option to convert their holdings into a continuation fund. It also would have forced firms to disclose any “material business relationships” the adviser has had with the independent opinion provider during the previous two years.
But the SEC rule was overturned by a Texas appellate court in June.
