Private equity’s latest hot product is causing a stir.
Continuation funds — sometimes called GP secondaries — are growing in popularity, but so are the challenges for asset owners. Investors say that their private equity managers have come to expect their clients to make a decision on whether to participate, or not, too quickly.
General partners create these products when they want to hang onto a promising portfolio company without extending the life of the private equity fund that holds it. Investors can then roll their existing investments into the continuation fund, or they can cash out.
But private equity managers expect their asset owners to make a decision fast — sometimes in just a week.
“LPs are being made to make a decision in a very short time frame for whether they should get their capital back or roll,” said Mina Pacheco Nazemi, co-head of funds and co-investments at Barings, during a panel at the 2022 TRS/ERS Emerging Manager Conference. “Making a buy/hold decision within a week-long period... is very unfair.”
These concerns are increasingly important as continuation funds give general partners the ability to raise new capital from investors who may have otherwise attempted to get into the fund using the secondaries market.
Tommy Albright, an investment manager who sits on the Teacher Retirement System of Texas’s co-investment team, has had experiences similar to Pacheco Nazemi’s.
“Over the past year or so we found ourselves being faced with these roll versus sell options and didn’t have a lot of time to decide,” he said during the panel.
For a co-investment team like Albright’s, other difficulties arise, especially questions of how to structure the co-investment attached to an old fund.
According to a report from law firm Torys, co-investors have taken different approaches to continuation funds. Some believe a continuation fund transfer could lead to a lower price for the portfolio company than another general partner may have paid. Because of this, some want to exit their co-investment position. Others are willing to roll, according to Torys.
“It’s not settled how those processes get run,” Albright said. “I encourage GPs to be transparent and give more lead time.”
What makes this more difficult is that continuation funds change the limited-general partner dynamic, putting limited partners into a decision-making position. While their fund managers would typically choose to sell or hold a company, allocators are now expected to do so.
“I understand from the LP perspective, the liability is being switched over from the GP to the LP,” Pacheco Nazemi said of the decision-making process. “You typically make your managers make these decisions. That’s why LPs opt to just sell, but I think they’re leaving a lot of money on the table.”
According to a report on continuation funds published by Mercer, those benefits can come in the form of cost-saving via reduced fees.
“Compared to a typical private equity fund, the fees are generally a bit lower, and the preferences are likely to be more in the LPs’ favor,” according to the report. “For example, there may be lower carry until it achieves its target internal rate of return (IRR) of perhaps 12 percent or 15 percent.”
“Not all continuation vehicles are created equal,” Pacheco Nazemi said. “We definitely do pass on them. It’s an area that’s here to stay, and it gives LPs the opportunity to get more liquidity.”