As beginning private equity firms, and future LPs, consider future endeavors, there is much to learn about private equity firms. The list is extensive, of course, but recently, a new term has gained popularity - ‘continuation funds.’ Private equity firms buying assets from themselves is a strategy worth understanding because its benefits allow PE firms to hold on to their assets longer, creating tremendous opportunities for every party involved.
Why do private equity firms buy continuation funds from themselves?
- Creates liquidity
- Extends the runway
- Realigns interests
- Tailors incentives
What is a continuation fund?
LPs expect a return on their investment in 10 years, typically the lifespan of portfolio assets. Continuation funds give investors of life-ending portfolios a chance to cash out or stay invested in the portfolio, but with a new vehicle (continuation funds).
5 reasons why private equity firms buy assets from themselves
After a particular portfolio has run its course of typically ten years, public equity firms cannot make the same return promises looking forward as they did initially at the start of the fund. To initiate a new promise that is more likely to be fulfilled, new terms, new economics for the General Partner, and perhaps additional capital for follow-on opportunities are added. Such reconstruction, as well as other factors (performance, revenue, scalability, etc.), also attracts new investors. New LPs, as well as existing investors, can see greater opportunity with a rebrand which in turn creates a sufficient fund for reconstruction. The PE firm still manages the assets and performances, however, and still collects management fees.
At the end of a portfolio’s lifespan, upon a PE firm buying their continuation fund, they give LPs the option to sell (cash-out). New investors of the continuation fund will make cash contributions which provide the liquidity for LPs elected to sell.
Extends the runway
General Partners may elect to hold onto portfolio assets longer with hopes of making bigger returns in the future. GPs can have solid assets they would rather not exit yet, and weaker assets with potential that just need more time to mature. With continuation funds, assets gain a new lifespan.
For a closer alignment of interest between the private equity fund manager and investors, a realignment is recommended. When a new continuation fund is discussed, interest factors come into play: carried interest, preferred return, GP commitment, management fees, fund extension, change of control, and many other considerations. Depending on the new circumstances, motivation can wane. Shared interests motivations can entice the GP and investors to pursue common company goals aggressively. LPs and GPs must be on the same page for successful portfolio management. And sometimes, to best get them on that page, incentives are offered.
Accomplishing goals using a company’s policies throughout short and long-run undertakings involving strategic risk aversion, risk-taking, interdivisional relationships, and company-division relationships are definitely appreciated in a private equity firm or any firm for that matter. Once a portfolio is restructured, it allows sponsors to add better incentive plans to ensure investors are kept onboard and perhaps increase their stake going forward into the continuation fund.
How does a continuation fund work?
- A private equity firm sets up a new fund
- With this fund, the PE firm acquires assets they’ve already held in a separate fund
- All existing investors can either cash out or roll their investments over into the new fund
- New investors contribute cash for existing investors if they decide to leave
Firms that have set up a continuation fund
- Audax Group - raised $1.7 billion to buy assets from Audax Private Equity Fund IV
- Ampersand Capital Partners - raised $670 million to buy three assets from a legacy fund
- Blackstone - sold $14.6 billion of property group BioMed Realty from one of its funds to another
- EQT - sold an enterprise software business for $3.6 billion from an older fund to a newer one to a new fund
Nordic Capital, BC Partners, and Hellman & Friedman are other reputable private equity firms that have sold assets to themselves.
5 of the most successful start-ups of 2020 (according to techstartups.com)
- Allbirds - shoes
- Bloomscape - potted plants
- Robinhood - stocks
- Divvy Homes - rent to own homes
- Calm - mental fitness
How to start your own equity firm (private equity guide books from Amazon)
- How to Start a Private Equity Firm Plus Business Plan
- Value Investing in Growth Companies: How to Spot High Growth Businesses and Generate 40% to 400% Investment Returns
- Dark Side of Valuation, The: Valuing Young, Distressed, and Complex Businesses
If private equity firms aren’t ready to sell particular assets that are near the end of its lifespan, continuation fund is an option to consider seriously. As investors have the choice of cashing out or rolling over into the new fund, the portfolio is now in a better position to increase value and perhaps grow to a worth beyond expectations, putting investors and employees of assets in better financial positions.