LPs are missing the boat when it comes to continuation funds – research

Investors who do not participate in GP-led secondaries opportunities could be incurring an opportunity cost of at least 15% over the long run, a study by Upwelling Capital Group has found.

Investors in private equity funds who shun GP-led processes could be missing out on significant upside, research from Upwelling Capital Group has found.

In research conducted by the consultant, LPs that systematically avoid rolling over their exposure to continuation funds are incurring a tangible opportunity cost of around 8 percent per vintage year. Compounded, the cumulative opportunity cost over a 10-year period “could be in excess of 15 percent of total cash-on-cash returns”, Upwelling noted in a report about its research.

“For every year an LP forgoes rolling into a [continuation vehicle], they give up an extra 15 percent-plus gain over the long run,” Upwelling founder Joncarlo Mark told Private Equity International.

The continuation fund market was worth around $52 billion last year, according to data from Lazard. Just over half of these by volume were for continuation funds that involved just one asset.

Research from Lazard showed that in the first half of this year, 90 percent of LPs chose to sell their exposure when faced with a continuation fund opportunity from one of their GPs.

The advent of continuation funds “fundamentally changes the way an LP has to operate”, Mark said. “They no longer can just make LP commitments and sit on their hands. That’s the biggest issue here – it’s forcing them to be responsive in a different way with their [general] partners.”

Continuation funds and GP-led processes have attracted attention this year from the US Securities and Exchange Commission, which has highlighted areas for potential conflicts of interest, as well as suggested best practices for running such processes in a fair manner for investors.

Upwelling’s research assumed the following:

  • A $1 billion per year investment pace
  • A median performance of entire portfolio being based on the TVPI of 2012-vintage buyout funds
  • Around 5 percent of an LP’s portfolio being offered up for continuation vehicles, based on separate figures from Bain & Co and Lazard on last year’s total buyout volume versus continuation fund transactions
  • A weighted average performance for continuation vehicles of 4.2x for single-asset deals, 3.2x for multi-asset deals where part of the fund has been involved, and a 2.6x for multi-asset deals involving all the assets in a fund (based on data compiled by Hamilton Lane in 2021 on continuation fund performance)
  • For LPs that sold when faced with continuation fund opportunities, proceeds were reinvested immediately on a primary basis with median returns
  • Fifteen percent carried interest paid to the GP at the end of year 10
  • LPs are only participating in GP-led opportunities offered by their existing sponsors

In Upwelling’s study, the delta for an LP participating in continuation funds versus selling was $153 million. Compounded over one decade, that leads to the 15 percent-plus difference, according to Mark.

LPs need to evolve

The short amount of time – sometimes 20 business days – by which an LP typically must respond to a GP running a continuation fund process, has led to some frustration from investors and is an area the SEC has stated it is looking into.

“When that email pops into your inbox, it’s the last thing you want to see,” the former head of private equity at a major US public pension told Secondaries Investor in July. “The default option is often an automatic sell, which seems like a pretty short fuse to me.”

Upwelling recommends that LPs and GPs strengthen their communication over potential continuation fund processes. LPs should be proactive in finding out from their GPs whether they are considering running a continuation fund process on one of their vehicles, and be “more active” in monitoring their managers and their underlying portfolios, while GPs should engage in regular dialogue to mitigate surprises.

Doing this will provide sufficient time for a thorough underwriting process of these opportunities, Upwelling noted.

The consultant acknowledges that doing this will require a change to LPs’ investment policies, processes and staffing. Investment policies should allow LPs to be “nimble”, such as delegating authority to commit to continuation funds. It also suggests LPs should clarify basic terms that need to be met if they are to rollover their exposure into a continuation fund, such as the minimum percentage of GP capital rolled, management fees, tiered carried interest and co-investment rights.

“It is a challenge if your plan is designed to make fund commitments and that’s it, but it’s reflective of the evolution of the asset class,” Mark said. “LPs are being asked to be more sophisticated today in the way they manage their programmes.”