This article is sponsored by TPG GP Solutions and appears in affiliate title Private Equity International’s GP-led Secondaries Special Report.
Why are we seeing so much growth in the use of continuation vehicles?
Michael Woolhouse: The secondaries market is a derivative of the overall private equity market, with the latter having experienced extraordinary growth in AUM over the past 20 years, from less than $1 trillion to almost $10 trillion and rising. We know that private equity fund structures have a fixed term, but those artificial constructs are not always appropriate for the underlying companies and do not always fit the time horizon during which sponsors are looking to achieve their objectives. Growth in the continuation vehicle market has been driven by the market’s ability to provide liquidity, while also allowing the sponsor to maintain ownership to deliver on another round of value creation.
Matt Jones: Sponsors want to hold on to their highest-quality companies rather than selling them to a competitor. The growth of the continuation vehicle market has also been driven by a dramatic increase in the willingness of secondaries market buyers to acquire single companies and concentrated portfolios. Five years ago, a high degree of single company concentration would have been considered unacceptable by many buyers. Today, GP-led deals represent over half of secondaries dealflow. That pace of change has been remarkable.
How large could this market potentially become?
MW: Virtually every sponsor in the world has one or two companies in their portfolio that they hold dear and would like to own for longer. The continuation vehicle is arguably the most effective way to achieve that objective. We believe the opportunities are vast and they will continue to grow as the private equity market becomes many multiples of what it is today.
What does the growth of the continuation vehicle market mean for LPs?
MJ: This market benefits both LPs invested in the underlying funds and, of course, LPs in the secondaries funds and dedicated vehicles tackling this opportunity. Existing LPs can receive liquidity at a fair price or remain invested in the company for the next stage of value creation. For those that elect to continue, the fee structure is typically lower and better aligned than is the case with the original fund. Meanwhile, with over half of exits today involving secondary buyouts, per PitchBook data, LPs have become accustomed to getting distribution notices one day and then capital calls for the same company the next.
The continuation vehicle market can introduce better economics and alignment for LPs on these deals relative to a straight sale to another sponsor.
Fundamentally though, continuation vehicles allow investors to participate in upside that may be clear for all parties to see, but that cannot be achieved within the current fund structure because the companies either need more capital or more time. Without the continuation vehicle market, all LPs would be faced with liquidating a company at less than its full potential.
LPs that have invested in the continuation vehicle market via secondaries funds dedicated to the space are able to access some of the highest-quality companies in the private equity market. There is clearly a positive selection bias – sponsors only choose to go another round with their very best companies. You could also argue that the continuation vehicle market offers the best alignment of interest available anywhere in private equity. Sponsors make outsized GP commitments because they want to share in the next round of value creation and there are bespoke carry waterfall structures that align incentives with the performance of the deal.
What are the constraints on this market’s continuing growth?
MW: The continuation vehicle market is certainly not constrained by the size of the opportunity set, in terms of the supply of deals. However, there are constraints around execution, including advisory capacity, and constraints in the buyer universe. New intermediaries, including some big brand name firms, have entered the market and bring additional advisory capacity to drive dealflow. We are also seeing new buyers enter the marketplace. These firms bring additional capital, with a select few offering differentiated capabilities to expand the marketplace beyond existing incumbents.
What are new entrants to the market bringing to the table that is different than the incumbent buyers?
MJ: One of the most important differentiators is sector expertise and the ability to establish valuations for single companies in a way that is perceived as credible by sponsors and their investors. Today, sponsors are often forced to go to another private equity firm to set the price of the continuation vehicle by taking a minority position. That is helpful in one sense, but it also necessitates another sponsor on the board of the company that they might not need or want.
MW: New entrants with differentiated capabilities will help expand the market, opening new forms of dealflow and encouraging an increasing number of sponsors to make use of these vehicles. We have already seen this happen in real estate and credit and now it is also taking place in private equity, supported by this push into single-company deals that demand sector expertise and built-for-purpose investment teams to diligence and underwrite these investments properly.
There are a lot of established secondaries firms that participate in this market, but their backgrounds are predominantly rooted in acquiring large, diversified LP portfolios and funds of funds. Buying single companies is a very different investment activity, requiring a very different skillset. In fact, I would argue that it is almost a different business to the traditional secondaries business that has developed over the past two decades.
With so many incumbent secondaries groups investing into single-asset and concentrated portfolio deals, how can it be a different business?
MW: We are seeing many incumbent secondaries buyers make smart decisions on how to leverage their primary fund of funds platforms and their LP secondaries business to expand into the single-asset and concentrated portfolio segment of the continuation vehicle market. But their core capabilities were built to acquire diversified private equity exposures with minimal single company concentration. For example, many existing groups have a 1 or 2 percent single company concentration limit in their legal documentation, which shines a light on what their LPs are engaging them for.
The new entrants, by contrast, have the advantage of being able to tailor their approach to this market opportunity and capitalise on rising demand without being encumbered by a legacy business. They can build an investment team with the right mix of direct private equity and secondaries skills, and the appropriate sector expertise.
MJ: I think that a lot of the incumbent secondaries managers approach these deals by relying heavily on alignment with the GP, rather than their expertise in the sector or company in question. Alignment is critical with these transactions, but it is no substitute for truly understanding what you are buying. Furthermore, true alignment can be hard to decipher with GPs equitising carry and generating new fees. Secondaries firms are writing some enormous cheques for deals today and so it is critically important to get that deep understanding. Focus initially on the company, and then layer the alignment on top. I think LPs will come to demand this from secondaries managers as the market continues to grow in scale.
What is the future of this market and why is it here to stay?
MJ: We firmly believe that the GP-led continuation vehicle market will continue to be the fastest growing area within secondaries. We have already seen explosive growth and we are only in the early innings. GPs are hugely incentivised to optimise the value of portfolios and to continue to back winners. LPs can participate in that additional value creation, or else take liquidity if desired, and buyers get exposure to the best companies in private equity, aligned with existing owners that know these businesses better than anyone. These are powerful dynamics that position the market for ongoing growth.
How should investors think about exposure to traditional LP secondaries versus continuation vehicles?
MJ: LPs need to think carefully about the exposures that they are looking for from their secondaries managers and about those managers’ abilities to deliver as the market continues to evolve. The nature of the underlying investment, the cashflow characteristics and return profiles are all very different – not better or worse, but different. The LP secondaries market is comprised of sponsors and companies that investors want to sell.
These are highly diversified portfolios with exposures to hundreds if not thousands of underlying companies and a short duration cashflow profile. It is also the most competitive segment of the market and various forms of leverage and recycling are widely employed to help amplify returns. Indeed, the traditional LP market almost acts as a private equity index. That has its place in many portfolios, but it is a very different strategy and return profile to the GP-led market.
MW: By contrast, the continuation vehicle market is characterised by sponsors that want to hold their best companies for longer. Portfolios are intentionally constructed to include a targeted set of companies where the sponsor has a clear playbook to drive further value creation with companies that they understand deeply.
In our experience, this is one of the fastest growing but least competitive markets in private equity today. Investors in continuation vehicles are also targeting much higher, private equity-like returns. It is the alpha section of the secondaries market, which is why it is growing so quickly and garnering so much attention from both incumbent secondaries buyers and new entrants.
Matt Jones and Michael Woolhouse are co-managing partners at TPG GP Solutions, TPG’s US and European secondaries investing business