(Bloomberg) - Private equity firms are using a form of financial engineering to buy more time for wringing returns from their under-achieving investments. Increasingly, their biggest clients are saying “no thanks.”
Ares Management Corp. weighed the idea, known as a continuation fund, but investors snubbed it earlier this year. New Enterprise Associates had to scale back a similar plan after talking to clients. By one gauge, only a third of the proposed funds have been getting done.
Continuation funds are among a growing array of asset-shuffling tactics that private equity funds are adopting because the normal way of producing payouts — selling assets — has been crimped by a feeble deal market.
In this case, managers slide hard-to-sell assets from an older fund into a brand-new one, akin to shifting an investment from one pocket to another. Meanwhile, the firm enlists new investors to buy into the continuation fund and cash out old clients — sometimes at a discount — while conjuring up a new stream of fees for managers along the way.
Clients don’t always see what’s in it for them. Data from Evercore Inc. shows continuation funds and other complex transactions fashioned by private equity firms fell 25% last year from 2021’s record $68 billion.
Some investors are balking at how continuation funds seem to reward managers for not getting the job done in time.
“We signed up for a 12-year fund. Now they’re asking investors to wait another seven years to get their money back,” said Brian Dana, a managing principal at investment advisory firm Meketa Investment Group. “It’s strange to me you won’t be done in the time you said you would.”
Across pension funds and endowment boardrooms, investors are taking a closer and more skeptical look at the contortions that private equity is using to get cash back to investors and drum up fees. The list includes various forms of borrowing such as margin loans, creating new share classes and complex securitizations that layer on leverage and risk, and investors are catching on to the full costs.
Cashing Out
Faced with the choice of whether to roll stakes into a continuation fund or cash out, Dana said his firm typically prefers to take the money and exit. That beats being stuck waiting, he said.
There’s also resistance when buyers and sellers disagree over what the fund’s assets are worth. With private equity sponsors effectively on both sides of the deal, the process is rife with potential conflicts of interest, and more pensions and endowments that bought the original funds are complaining that they’re tired of deals where they wind up on the losing end.
Earlier this year, Ares explored rolling some investments from its 2017 vintage Ares Corporate Opportunities Fund into a continuation vehicle to generate distributions. After hearing out key investors who asked the firm to keep the assets in the existing fund, Ares shelved the deal, people familiar with the matter said.
New Enterprise Associates, a venture capital firm, started exploring a continuation vehicle last year and cut the number of companies in the fund after getting feedback from investors, said people with knowledge of the matter. NEA structured it to mitigate conflicts and align interests, one of the people said.
Representatives for Ares and NEA declined to comment.
Only about a third of continuation funds that are contemplated are actually completed these days, down from about 80% in 2018, when the market was a lot smaller and newer, according to Jon Costello, founder and managing partner of Devon Park Advisors.
“Probably two-thirds should get done,” he said, but there’s not enough capital available to meet the demand from private equity firms for such deals. “The last third probably shouldn’t have been brought to market.”
Managers typically sell investors on continuation funds with a simple pitch: By holding on to an asset for longer, they can maximize returns over the long haul.
The reality can be more murky. Many sponsors turn to a continuation fund only after they explored other routes to a sale that wouldn’t have produced a profit.
New investors that back continuation funds are typically firms that specialize in buying second-hand stakes. These so-called “secondaries” firms typically drive a hard bargain and seek discounts. They occasionally come together as a consortium, with the lead buyer speaking for about 25% to 30% of the deal.
Falling Short
Sometimes, though, there just isn’t enough demand to make a continuation vehicle worth it.
The vast majority of the original investors in the asset typically opt to take their cash and not participate in the continuation fund. Some pensions can’t easily commit to a continuation fund without going through layers of decision-makers.
What’s more, certain deals allow managers to reap carried interest, the industry’s favored form of compensation, simply by moving it from one of their funds to another. Pensions and endowments say managers deserve profits only after exiting a business or taking it public.
Investors also complain that if only the marquee asset goes into a new fund, the deal looks more like an expensive version of directly co-investing in a portfolio company alongside the manager. A co-investment typically has no fees.
In a sweeping bid to regulate private equity, the Securities and Exchange Commission tried requiring firms that designed complex secondary deals to hire independent auditors to ensure investors get a fair shake. A court blocked the rules.
An influential trade association for private equity fund investors published guidance on continuation fund deals last year, saying managers should be transparent and clear conflicts with major investors. Brian Hoehn, director of industry affairs of the Institutional Limited Partners Association, said firms are working more to notify investors.
Opting In
Sometimes investors are persuaded to go along.
Cinven considered moving chemicals company Barentz into a continuation fund late last year and asked big investors to waive conflicts of interest. The firm faced pointed questions, including whether they did enough to net the best price, according to people familiar with the matter.
Options including a public offering were considered and third-party advisers set the valuation, another person said. Cinven also offered to let clients keep investing on the same terms as before. The investors ultimately agreed, and Netherlands-based Barentz ranks among the firm’s top performers, one person said. Cinven declined to comment.
Despite the growing skepticism of continuation funds among private equity clients, one industry participant predicts the vehicles will continue to grow as sponsors remain under pressure to generate cash.
“Sponsors need to get creative with their limited partners,” said Nigel Dawn, Evercore’s head of secondaries. He predicts that continuation funds will have a record year.
By Allison McNeely and Dawn Lim
With assistance from Marion Halftermeyer
