Private equity firms are increasingly resorting to financial tricks to buy more time and generate returns from their underperforming investments. As a result, many of their largest investors are starting to say, “no, thank you.”
This year, Ares Management Corp. considered implementing a “continuation fund,” but investors quickly dismissed the plan. Similarly, New Enterprise Associates had to retrench from a similar approach after consulting with its clients. As a sign of the times, only a third of the proposed continuation funds have actually been realized.
These continuation funds are just one of several strategies employed by private equity firms after the downturn in the mergers and acquisitions market disrupted their usual method of generating returns, which typically involves selling assets from their portfolios. In this situation, managers shift hard-to-sell assets from an old fund to a completely new one, akin to transferring an investment from one pocket to another. This helps the firm attract new investors while also settling with previous clients—often at a discount—while creating new commission streams.
However, investors are not pleased. According to data from Evercore Inc., transactions involving continuation funds and other complex deals dropped by 25% last year from a record of $68 billion in 2021. Some investors criticize the way continuation funds seem to reward managers for failing to meet their original timelines.
“We sign up for a 12-year fund. Now they’re asking investors to wait another seven years to get their money back,” said Brian Dana, managing director at Meketa Investment Group. “It seems strange that they can’t finish on time.”
Clients are scrutinizing the maneuvers of private equity firms more closely than ever, particularly concerning how they plan to return money and generate fees. These maneuvers include various forms of debt, such as margin loans, new share classes, and complex securitizations that increase leverage and risk—and investors are becoming increasingly aware of the associated costs.
When faced with the choice between reinvesting in a continuation fund or taking cash, Dana noted that his firm typically opts for cash. It’s a better option than being stuck waiting, he said. Tensions also arise when buyers and sellers disagree on the value of a fund’s assets. Often, private equity firms find themselves on both sides of these asset sales, creating potential conflicts of interest, and more clients are voicing concerns about ending up with unfavorable outcomes.
This year, Ares contemplated transferring some investments from its 2017 Ares Corporate Opportunities Fund to a continuation fund to facilitate cash distribution. However, after discussing with investors who preferred to keep the assets in the existing fund, Ares abandoned the idea.
New Enterprise Associates also considered creating a continuation fund last year. After receiving feedback from clients, they reduced the number of companies in the fund and structured it to mitigate conflicts and align interests, according to insiders. Representatives from Ares and NEA declined to comment.
These days, only about a third of proposed continuation fund projects are actually completed, a steep drop from around 80% in 2018 when the market was much smaller and less mature. Jon Costello, founder and managing partner at Devon Park Advisors, estimated that two-thirds of these funds should be moving forward, but there isn’t enough capital available to meet private equity firms’ demands for such transactions.
Managers often try to convince investors that by holding onto an asset longer, they can maximize long-term returns. However, the reality is more complex. Many sponsors turn to continuation funds only after exploring sales that would not produce profits.
New investors backing continuation funds are typically specialized firms that focus on purchasing second-hand stakes. Known as “secondary” firms, they often drive hard bargains and look for discounts. Sometimes they form consortia, where the lead buyer represents 25% to 30% of the deal.
At times, demand for a continuation vehicle simply isn’t sufficient to justify its creation. Most original investors tend to withdraw their money in cash rather than participate in a continuation fund. Additionally, some pension funds cannot commit to a continuation fund without obtaining multiple approvals.
Moreover, certain transactions allow managers to collect preferred “carried interest” simply by transferring assets from one fund to another. Pension funds and endowments argue that managers should only realize gains after selling a business or taking it public.
Investors have also noted that if only the star asset moves to a new fund, the arrangement resembles an expensive direct co-investment in a company, which typically doesn’t incur fees.
In an effort to regulate private equity, the Securities and Exchange Commission attempted to require firms engaging in complex secondary transactions to hire independent auditors to ensure fair treatment for investors. However, a court blocked this request.
Last year, a notable association of private equity fund investors issued guidelines on continuation funds, asserting that managers should be transparent and clarify conflicts with leading investors. Brian Hoehn, director of industry affairs at the Institutional Limited Partners Association, mentioned that firms are making more efforts to inform investors.
Sometimes, investors can be persuaded to participate. Cinven considered moving the chemical company Barentz to a continuation fund late last year, seeking large investors to waive conflicts of interest. The firm faced tough questions about whether they did enough to secure the best price. Options discussed included a public offering and external advisors helped determine the valuation. Cinven also offered clients the chance to invest under the same conditions as before. Ultimately, investors agreed, and Barentz, based in the Netherlands, is now among the firm’s most lucrative investments.
Despite skepticism surrounding continuation funds, an industry participant predicts that such vehicles will continue to grow as sponsors face pressure to generate cash.
“Sponsors need to be creative with their partners,” said Nigel Dawn, head of secondary operations at Evercore. He forecasts that continuation funds will have a record year ahead.
Source: https://www.perfil.com/noticias/bloomberg/bc-trucos-en-la-industria-del-capital-privado-estan-colmando-la-paciencia-de-sus-principales-clientes.phtml
