Given the expectation that managers will roll their carry into continuation funds, the market should expect to see some nuances in how such transactions take place: for funds that have a US-style, deal-by-deal, blind pool waterfall, as opposed to ones that have European-style, fund-level waterfalls, an increasing number of these transactions can be expected to come out earlier in the life of the fund.
Fund managers in European waterfalls do not receive carry until all of the LPs’ capital and preferred returns have been realised. This means calculating what is available to reinvest is a lot less cut and dried compared with deal-by-deal vehicles.
“Single-asset continuation funds work better in American-style waterfalls, while they are a lot more complicated when it comes to European-style waterfalls,” says Immanuel Rubin, head of European secondaries at Campbell Lutyens.
Senior investment professionals within the GP, as well as other key players critical to the success of such deals, will be expected to roll a meaningful amount into the new vehicle, with carry a crucial component. This amount is bespoke to each transaction and will contribute to creating alignment for all parties – crucial for getting a successful deal over the line.
“This is what alignment means to me: GPs have the ability to lose value or lose something, but they also have the ability to gain something if the deal goes well. We want both present in a transaction,” says Verdun Perry, global head of Blackstone Strategic Partners.
Buyers looking at these individual situations will be able to tell how important something is to a GP, especially when it comes to overall economics and what you expect them to contribute, says Dushy Sivanithy, managing director and head of secondaries at CPP Investments. “I do think people are receptive to [the fact that] the level of alignment needs to be appropriate for the risk we are taking in some of these transactions.”
LPs, too, want to ensure they’re not being fleeced by their managers. If you have a European-style waterfall, “you could face an awkward conversation where the manager wants to retain some of the carry because [it has been generated by the whole fund’s performance and] it doesn’t all relate to this deal”, says James McCredie, a partner at Macfarlanes.
Deals that take place early on in a fund that has a European-style waterfall will be the exception, not the rule, Perry says. “The rule will be older assets, where it’s a defined amount of crystallised carry that they can roll into a transaction that is sizeable.”
What Perry would like to see in an exceptional situation is a manager who is willing to write new cheques to invest in the same pool of assets. This could also come in the form of an existing fund investing in the opportunity.
Other options could be on the table. Mark McDonald, managing partner of DWS’s private equity business, says there are increasingly sophisticated tools that managers can use to create future alignment: these include using debt or preferred equity markets to securitise future carried interest payments on incumbent funds, or bring forward GP commitments to new continuation funds.