The prevailing narrative in private equity these days is that GP-led continuation fund deals are the hottest ticket around: that every GP is ready to run a process to extend its hold over a treasured asset, while simultaneously delivering proceeds back to LPs in older funds and capturing a new stream of fees.
The reality though, appears to be that limited partners have concerns that continuation funds, as well as other alternatives to liquidity like NAV loans, as potentially disrupting their relationship with managers.
Goldman Sachs put out fresh research recently, surveying more than 200 LPs and GPs, that found that a large swath of LP respondents believe continuation funds and NAV loans negatively impact the alignment of their relationships with GPs.
The survey also found that one in five GP respondents said they expect traditional M&A asset sales as the main path to liquidity over the next year, with continuation funds as the least likely option, even behind IPOs, according to the survey.
A disconnect exists in the industry between GPs who view continuation funds as a desirable way to hold certain assets beyond the limits of a traditional private equity fund, and LPs who generally would prefer a regular exit.
GP-led secondaries provide GPs with a way to deliver liquidity to LPs in older funds, create new fee streams and bring in fresh capital from outside investors to continue growing the asset. LPs generally have the option to sell – in this market at some level of discount – or roll their interest in the asset or assets into the continuation fund. LPs who choose to roll generally have to agree to some new terms – maybe a new management fee or carried interest rate, at the very least a new time frame for holding the asset.
Many GP-led deals come with a “status quo option”, which allows existing LPs to essentially do nothing: make no decision and simply keep their interest in the asset on the same terms they had in the older fund, with the only exception being the new time horizon. This is considered the “LP friendly” structure in GP-led deals, but not every transaction includes a status quo option. Some deals, especially those that happened before the market downturn last year, only allowed LPs the chance to either cash out of their interests, usually at strong pricing, or re-invest in the continuation fund on the new terms.
The alignment questions arise with the idea that a GP could get new fees and carry potential out of an older asset. Rather than simply selling, which is what many LPs would like to see, the GP is engaging in a complicated and conflicted process that will involve further expense and analysis on the part of LPs.
As well, the GP may be plucking the best performing asset out of a fund and locking in carried interest on that one deal, even if the main fund drops out of carry without its superstar portfolio company.
Time, expense, potential misalignment are some of the factors that go into the LP concerns when it comes to continuation funds.
NAV loans have a similar profile for LPs. In this case, GPs are monetising a fund’s portfolio for various reasons: to continue expanding existing investments or to help bridge them through challenges; to distribute proceeds to LPs seeking liquidity from older funds; or even to pay down debt approaching maturities.
NAV loans, which have been around for years, gained momentum last year as LPs chose not to sell on the secondary market because of deep discounts. The market for NAV-based financings is estimated between $80 billion and $100 billion, affiliate title Buyouts recently reported. Around $30 billion of NAV deals were completed last year, the report said.
“This market has more than doubled in the last two years and continues to see tremendous growth and acceptance, similar to the growth in the LP- and GP-led secondaries markets,” Dave Philipp, partner at Crestline Investors, told Buyouts.
One senior investment officer at a large public system said they have been pushing back on their GPs who are considering floating NAV loans for various reasons.
“We’ve definitely communicated to our partners that we’re not happy about it,” the investment officer said. “If it’s just an effort to try to generate DPI to make that metric look good, in my mind that’s artificial.”
A more reasonable scenario would be a portfolio with debt approaching maturity that needs to bridge a challenging time, the investment officer said. “If that’s the best solution to deal with it, that’s an example where we could work through it as an opportunistic situation to take the least bad path,” the investment officer said.