After a so-called “lost year” when private equity deal volume slumped amid sky-high interest rates, buyout executives are eager to put vast sums of capital to work – even if practically speaking it’s simply moving money around.
Enter the “continuation fund”: A way of rolling over assets from one fund to another in the same firm. Clients of private equity firms – commonly referred to as limited partners, or LPs – can typically liquidate their holdings if a given fund fails to exit an investment over a certain time period, usually between three and five years.
A continuation fund, however, presents a second option: Hold onto the investment and bet that a bigger payday will come down the road.
In these increasingly popular deals, private equity firms sell their own assets at the highest justifiable price they set to a new fund they also control.
The selling fund of the firm collects their fat, 20% carried-interest fee and their continuation fund, which they also control, gets to put their capital work enjoying the 2% management fee at the, typically, higher valuation then the selling fund had on their books.
Last year, L Catterton created a continuation fund to sell its healthcare platform, Patent Point Health Technologies, to itself.
ArcLight Capital Partners created a continuation fund to roll over its investment in midstream infrastructure platform Third Coast to another fund. BV Investment Partners created a continuation fund to roll over its cloud solution company into a new fund.
Experts predict the vehicle could see the same kind of craze in the coming years that SPACs did in 2020 and 2021.
“Continuation funds are the hottest thing in the industry,” Jeffrey Hooke, senior finance lecturer at the Johns Hopkins Carey School of Business said. “A continuation fund is the means to sell deals and try to show some profits.”
“Stuff is just sitting on the shelf and they can’t sell it,” he adds. “It’s incredibly important for these funds to show they’re making progress with the investments.”
With the PE market having swelled to a nearly $2.6 trillion, according to S&P Global Market Intelligence, there is plenty of capital to create new funds that will acquire these assets.
Some market watchers, however, are concerned that continuation funds will send valuations to artificially high levels since the companies in the portfolio don’t have to be evaluated for an IPO or another more public forum.
“The way they maintain fiction is they bring almost none of their companies to market,” Eileen Appelbaum, Co-Director of the Center for Economic and Policy Research said. “If any of these funds brought them to market they’d have to reevaluate all the companies in the portfolio.”
Mikkel Svenstrup, CIO of Danish pension fund ATP has already said all the circular deals put PE firms in danger of becoming “pyramid schemes.”
“Everyone can see it’s just financial engineering,” Hooke adds. “But all the people who work at these pension funds and investment vehicles need to justify their existence.”
“PE funds have more money than ever before,” Appelbaum adds. “But the future isn’t bright for investors.”
This story originally appeared on NYPost
