As we travel the world in search of investment opportunities, we encounter certain misconceptions about the continuation vehicle, an instrument for implementing general partner-led secondaries strategies. Continuation vehicles, or CVs, remain a misunderstood market innovation – here, we address some of the most prevailing myths.
GP-led secondaries transactions are unfair to primary fund LPs, since CVs are designed with only the GP’s goals in mind.
Continuation vehicles are designed as a liquidity mechanism that attempts to reconcile a GP’s desire to hold high-performing assets for longer with the need for some LPs to achieve liquidity sooner. Both perspectives can be accommodated by presenting LPs with the option of either taking liquidity or rolling exposure into the new CV. Such interim liquidity options represent a positive development for outgoing investors, incoming investors and the sponsor. Existing LPs achieve liquidity typically at multiples of their cost, given the high-quality nature of the assets involved, and incoming investors gain exposure to assets poised to continue performing well over a multi-year horizon. Transparency, optionality and a market-clearing pricing mechanism are critical to creating a win-win-win transaction for all parties.
Valuations aren’t set by the market, and CVs don’t achieve full value for legacy LPs.
Most CVs price assets at or near the most recent net asset value and often can price above the NAV depending on market conditions or the company’s performance. The majority of transactions are designed to achieve true market-clearing value by retaining an adviser to run an M&A-style process that includes price discovery from multiple secondaries funds or another sponsor; furthermore, third-party fairness opinions often are used as well. It is important to remember that asset-level pricing includes underwriting multiple years of future appreciation and often the inclusion of new risk capital to support growth initiatives. We believe these factors help discipline the market and provide balance in risk/return evaluation for both existing LPs and future investors.
Misconceptions about continuation vehicles abound
CVs frequently involve weaker, poorly performing tail-end assets that a sponsor can’t sell.
In our view, today’s CVs almost always contain exposure to the highest quality assets in a sponsor’s portfolio. When GP-led secondaries started in earnest a decade ago, weakened sponsors were often seeking to relaunch their franchises or extend fund duration with lower-performing assets. Now, strong sponsors across the world view CVs as a portfolio management tool – an alternative on par with exits through an M&A or IPO process. This evolution in exit planning allows a GP to evaluate all outcomes, including holding a high-performing asset longer and continuing to compound returns. Structural features demanded by the secondary market – including rolling any crystalised carry and original GP commitment, and requiring a GP to invest new capital into the CV – all work to reinforce the notion that GPs create CVs with some of the highest quality assets the private equity market has to offer. In fact, from a risk/return perspective, this interim liquidity point might be considered an optimal time to participate in the potential appreciation of the asset.
Extra layers of fees associated with CVs depress returns.
CV fees are lower than those for primary fund commitments and, more importantly, there are other factors far more influential to investment success in GP-led secondaries. Concentration demands higher investment hurdles, so the base underwriting cases are higher for CVs than for traditional LP secondaries. This, coupled with structural factors that provide GPs with an incentive to include high-performing assets, makes investment acumen matter much more than fee friction. Sourcing, underwriting, optimising deal dynamics and constructing a portfolio at a granular level afford a chance to achieve enhanced returns. Furthermore, from a risk/return perspective, a portfolio of CVs with manager continuity and the benefits of midlife investing presents an appealing opportunity to complement primary fund commitments, co-investments and exposure to traditional LP secondaries investments.
CVs are simply co-investments with fees.
Roughly half of CVs contain multiple assets and, by extension, are clearly different from co-investment transactions; however, even the remaining half of CVs – single-asset continuation vehicles – are quite distinct from co-investments. In a CV transaction, the sponsor is already a seasoned owner of the asset, affording the sponsor an intimate understanding of the company’s operations. All else being equal, the prospective risk of an asset a sponsor has long owned is materially lower than that of a new investment made by the sponsor for the first time.
GP-led secondaries – which represented more than half of the secondaries market transaction volume in 2020 and 2021 – have proven to be a durable innovation, mutually beneficial for GPs, primary fund LPs and new secondaries investors alike. GPs get to extend ownership of successful investments, existing LPs can take liquidity or stay invested, and new secondaries investors get to participate in the upside of seasoned, hard-to-access portfolio companies. Our view is that GP-led secondaries have become an essential function for private market participants of all types and deserve to be recognised for what they are: a vital portfolio management tool that balances the unique and nuanced needs of each participant in the transaction.
Jeff Hammer and Paul Sanabria are global co-heads of secondaries, private markets, at Manulife Investment Management.