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A RopesTalk podcast series from Ropes & Gray’s sponsor solutions group focused on issues that matter most to private equity sponsors.
Deb Lussier: Hi, everyone. I’m Deb Lussier, a partner and co-leader of the sponsor solutions practice at Ropes & Gray. Welcome back to our podcast, A Word for Our Sponsors, where we talk with private equity insiders about the issues that matter most to them. This episode is the second in a two-part series. I’m once again joined by my colleague Marc Migliazzo, counsel in our sponsor solutions practice, and Jon Costello, the founder and managing partner of Devon Park Advisors. As a refresher, on the first part, we discussed the growth and evolution of GP-led secondary transactions, the increasing acceptance and strategic use of continuation funds by sponsors, and the importance of planning and communication when considering these transactions. Today, we’ll continue our discussion with Jon on the evolving landscape of the GP-led secondary market.
Jon, on the prior episode, you mentioned that there’s been a number of new entrants into the market and new advisors. More recently, we’ve seen dedicated secondary platforms launch at large private equity houses, such as Leonard Green, Accel-KKR, and others. What parts of the GP-led market do you think are most likely to change or evolve as a result of these new investors on the buy side?
Jonathan Costello: Our view is we’re still at early innings, in terms of capitalization of the overall opportunity set. There are only a few examples of groups who can show up and are comfortable doing an entire deal. We’re still in the market structure, where it’s a club of leads for larger deals, and then an increasingly larger syndication process. In a well-functioning sell-side M&A process, you have multiple bids for the asset, and you can choose your path forward, based on execution certainty, familiarity with the industry, and prior experience working with that group. I think the market has a long way to go until we get to that point, and I think we need to get to that point, in order for there to be massive growth. This market’s going to continue to grow and evolve, but I think we need more groups who are willing and able to step in and speak for the entirety or 75-80% of the deal, and you need more than one of them in each process. I think, maybe, some of these new entrants who have sector expertise are going to be more comfortable making those bets in size and in concentration at real scale. So, I’m super excited about the new entrants that you mentioned, and there’s many more, I think, in formation.
There are also two other trends that I think are pretty meaningful. One is you’ve had some former private equity leaders who now have established single-family offices or multi-family offices with their friends, and they’re very excited about the continuation fund opportunity. They think it’s a great way to invest, and they’re trying to organize themselves to have some real scale. While they’re not, maybe, affiliated anymore with their prior firm, they bring decades of expertise in specific sectors. So, I think we’re going to continue to see evolution there in a way that will also just organize more capital around individual opportunities. If someone who’s known to have a track record in that space is coming in in size and saying, “I like this asset. I like it at this price. I want to partner with this sponsor,” I think it will attract other capital. And then, I think, more broadly, we’re seeing single-family office interest in the strategy coming directly into some of our transactions.
Marc Migliazzo: That’s interesting. To drill down on that just a bit, in terms of realizing a vision, where there’s fewer club deals and more single-investor backers of these sorts of continuation funds, is it merely a question of scale, of assets under management by a given investor, or do you think there’s other factors involved which are making lead investors not as comfortable as you might like in backing entire funds themselves?
Jonathan Costello: I think it’s a combination of those things. If you think about the current lead buyers in continuation fund transactions, at least, today, there seems to be more comfort, in terms of size in multi-asset transactions. If you were to look at an LP portfolio that one of these same groups might buy, there tends to be some concentration, at least, in the top assets. And so, a multi-asset deal, in some ways, presents somewhat similarly to where they deploy the majority of their capital. As we get more and more concentrated, I think, just from a portfolio construction basis and risk management, check sizes come down. So, that’s on the demand side. On the supply side, I think the purest of these deals is the single-asset deal. I think sponsors, if they had the choice, they would prefer to do mostly, if not all, single-asset transactions.
Those two worlds, it would be too strong to say they’re in conflict with each other, but I think there needs to be a new set of investors that emerges that is comfortable taking single-asset risk. Those are probably going to be platforms that are led and capitalized by LPs that have confidence in the teams to make those targeted bets. And if you’ve got the larger sponsors wanting to do these deals—you’re talking about equity checks of $250 million to $1 billion—that’s a big bet, even in the context of the traditional private equity market. So, I think we’re going to get there, but we’re still in pretty early stages, in terms of solving the capital need to do the type and the quantum of transactions that the market, I think, wants to see happen.
Deb Lussier: You mentioned single-family offices. Is there also a role for sovereign wealth funds?
Jonathan Costello: Yes, definitely. I think they’re watching this space, and I think they’re playing a role in situations where they have a preexisting relationship with the sponsor and it’s an asset that they really like. I think the friction in that market is just fees: What fees does a sovereign wealth fund want to pay for basically a minority-direct investment? And so, I would say that’s been the only impediment to, probably, more activity coming from those types of investors. We’re seeing pockets of that, for them playing roles in some of the very large transactions, but my view is they’ll probably continue to play a role in that segment of the market because they all have very active minority-direct equity programs—that does fill a void in certain situations today. That’s not 100% aligned with what sponsors are hoping to achieve, from an economics perspective, but helpful in getting the deal done.
Deb Lussier: I wonder if on the primary fundraising side—where co-investment has, for many, almost become a prerequisite for investing in a fund in order to have a better blended fee and carry rate—whether we might start to see a change in terms on the continuation funds or some piece of the asset being held to the side, and treated like a co-investment, and offered to the buyers on a either reduced fee and carry or no fee and carry basis?
Jonathan Costello: I think, to your point, it’s like these are highly bespoke negotiated transactions. There’s a lot of terms that are negotiated during a traditional sell-side process, that some of those things have made their way into these types of deals. Performance-based purchase prices would be one example, where it’s tied to hitting specific EBITDA thresholds. I think we’ve seen some of that in sharing of outperformance between this record day concept in closing—sometimes, that period is long, and so, there needs to be evolution, I think, in the mechanics of how these deals ultimately get prices and what proceeds then flow to the underlying selling LPs. I think we’re starting to see some of that make its way into the market today.
Deb Lussier: Jon, do you see other applications for this technology, as you look ahead and think about what lies ahead in the future for continuation funds?
Jonathan Costello: We’re starting to see two major trends. One trend is basically trying to be more on the offense. Some creative things that we’ve seen done in the market, and we’ve been involved in, include things like the investment that’s been in someone’s portfolio for a while—it’s done extremely well, it then went public, and, maybe, it didn’t perform as well in the public markets. We recently completed a deal that involved our client doing a take-private through a continuation fund transaction, and then, on the back of that, because it’s very challenging to get the traditional investors and continuation funds to play a role in an asset that’s public, we had to do it in two steps. First step was we found someone who was willing to support our client in the take-private deal with limited governance and paying economics to our client, and then, on the back of that, provide a liquidity option to some of the original investors. Obviously, that price investigation involved a special committee of a board, fairness opinions, and all of the things that you would expect would be required of a public company. And so, that was a pretty unique application of it.
The other thing that we’re seeing more of is—and there’s a term of art I think the people are starting to use—the opportunity in “mid-life” assets. Those are situations where they may or may not be ready for a continuation fund, but there’s either a desire for liquidity, partially, for portfolio management reasons at the fund or there’s a capital need to fund organic growth or major acquisition. There’s a way to execute these deals without doing a full continuation fund that presents very much like a minority equity recap. And we’re seeing a lot of interest in these types of transactions, particularly for younger assets, that have performed really well, but have now become quite large in the context of the existing fund. Maybe that existing fund, again, for portfolio management reasons, needs to re-balance its exposure—is being encouraged by its LPs to re-balance that exposure. At the same time, they’re still so early in the investment cycle for this deal that they want to continue to deploy more equity into the business, and we see a trend and a big opportunity there. So, those are just some examples of deals, where we see the new applications being applied.
Deb Lussier: Jon, on the second trend, is it a partial continuation fund on an asset? Does it provide liquidity and taking some cards off the table, but the existing fund continues to own a piece of the asset? Tell us more about that.
Jonathan Costello: Yes, it’s all of that. It’s bringing in a new investor that’s coming in at a different basis than the fund. It’s helping in a third-party negotiated transaction—it’s helping get a third-party mark on the deal. Maybe the sponsor decides to sell a little bit of its equity into the deal to make the deal a little bit bigger for the investor—return some capital to LPs. There could be economics for the sponsor associated with that investment. One of the areas we see is when you have these companies that are buy and build that are on a very good trajectory, you can continue to recap them on the debt side or what have you. But, sometimes, you still need a new equity slug, and it might just be at a point in the fund that currently holds the asset’s life that, either for portfolio management reasons or whatever, they’re not able to actually inject that equity, so they need to go to a third party to do that. So, it’s in a case where, maybe, it’s too early for that investment to move into a continuation fund transaction. We didn’t really talk about this earlier, but I think concentration risk in a fund is a motivation for why some continuation fund deals get done. If you’re sitting on a massive return early in the fund life, a disproportionate share of the funds return is tied to the outcome of that investment, and I think both sponsors and their underlying LPs are very much aware of that. And so, this was kind of a half step in lieu of a full continuation fund deal.
Deb Lussier: Evergreen funds are difficult because of valuation issues and the desire for liquidity, at some points, and the tension between those two concepts. Jon, could you imagine that this new technology could bring us closer to that holy grail, where assets are held by sponsors on an indefinite or permanent basis?
Jonathan Costello: There was a time when there was this ambition, from particularly larger cap sponsors, to create these long-dated permanent capital funds, and I think that the LP reception to that was more muted than people expected. It was around that 2018 timeframe, if I recall. I think the continuation fund adoption by some of the larger sponsors was in reaction to that. And so, one application of continuation funds became almost, like, a deal-by-deal long-dated fund. The issue was—and continues to be—that some of the secondary players have more three-to-five-year durations, and the sponsors, when they’ve identified an asset like this, would like to own them five to 10 years. And so, you’ve seen some language or technology creep into these documents that would allow for a CV of a CV or, maybe, a longer term for the fund but with an off ramp or a potential partial liquidity option being offered that would accommodate the secondary firms. I think one of the interesting trends that we’re seeing is there are some secondary funds that are trying to do more registered fund products, which would then be evergreen in nature, and then, they might have, by mandate, the ability to hold the assets longer. Three to five years with an asset that’s done well is a reasonable amount of time, but I think the market wants to move to a longer duration akin to what you’ve seen in the infrastructure space, with these interim liquidity options or off ramps that are built into the documents.
Marc Migliazzo: I had a question for you about management teams who are often promised at the outset of an investment that they themselves will see some sort of liquidity event after a certain number of years. I’m curious what conversations you tend to have with sponsors and with secondary investors over how to treat management in these sorts of transactions?
Jonathan Costello: Management teams are hearing about these more and more, and they’re getting their own counsel and advice on what market is. I think that that goes back to the planning process. If you’re well-prepared before you launch a deal, you have that conversation with the sponsor and that sponsor has the conversation with the underlying management team. I think there is a willingness for liquidity to be provided to underlying management teams, as a part of these deals (not in every case). There’s clearly a re-incentivization that occurs through new management incentive plans that are put in place as part of these deals. We’ve seen everything across the spectrum of, this isn’t treated like a change of control transaction—it’s a continuation of their incentive program. Maybe there’s some vesting that occurs. We’ve seen other cases where there’s partial liquidity and a reload of that incentive on a go-forward basis. So, I think that a lot of the lead investors in the secondary deals, they’re really looking for a sponsor to tell them what they think is important to make sure management’s aligned with this next phase of the business plan. Another key consideration, I think, sponsors have when they’re preparing for a continuation fund transaction is what to do with the economics on a go-forward basis. Continuation funds provide an interesting opportunity to cash out former partners and, even more importantly, incentivize, maybe, newer partners that have been involved in this asset since day one but didn’t participate as much in the value accretion to date, and there’s just great opportunity to re-incentivize them and create strong economic alignment on a go-forward basis.
Marc Migliazzo: Jon, thanks for joining us today for this terrific conversation. We really appreciate it.
Jonathan Costello: Marc and Debra, thank you very much for this opportunity. We’re really excited about the prospects of the continuation fund market, both in the near term and over the longer term. To the extent any of your clients or anyone listening to this podcast has any questions or we can be helpful, as you think about continuation fund transactions, please reach out—you can find all of our contact information on devonparkadvisors.com.
Deb Lussier: Jon, thanks again for sharing your insights. And thanks to our audience for joining us on this second part. For more information on the topics that we discussed, please visit our website at ropesgray.com. Of course, if we can help you navigate any of the topics that we discussed, don’t hesitate to get in touch with us. You can also subscribe to A Word for Our Sponsors anywhere that you listen to podcasts, including on Apple and Spotify. Thanks again for joining us.