3. Continuation Vehicles
Traditional Exit Routes, Continuation Vehicles and GP-led Secondaries
Traditionally, private equity firms (“GP” or “Sponsor”) look to exit their investments via 1) a sale or 2) an IPO.
The sale can be to strategic or a sponsor. The GP will hire a bank to run a process hoping to find the “right” buyer (combination of price and simply who they want to partner with).
The alternative, an IPO, depends on 1) the IPO window being open and 2) the company fits the profile of an IPO candidate.
The IPO window opens and closes alongside broad market performance. In 2021, for instance, the IPO window was very much open. In 2023, however, it is very much closed as of March.
Simply put, the sponsor buys a business hoping to create value during their hold period. After ~5-7 years, they will exit the investment via one of the options above (sale or IPO). Sponsors generally know early-on in the investment’s life which option they will use to exit. In some cases, the sponsor will run a dual-track process, exploring both a sale and IPO.
You can quickly see one of the pitfalls of IPOs is that it depends upon a healthy IPO window. When it’s closed, you can’t get your IPO through no matter how great of a candidate.
A similar “pitfall” for sales in today’s market is that it relies upon debt financing. LBO / M&A volume has been muted for the last ~12 months as debt markets are shut. On the supply side, banks are not lending to new LBOs, at least in any size compared to recent years. There may only be a handful of new committed financings since June. On the demand side, initial sponsor appetite for loans and bonds in a higher interest rate environment has been muted.
So, exiting via a sale is hard in this market because it relies upon the buyer tapping the debt markets…which are largely closed.
But, sponsors are creative and can find alternative ways to get realization.
That leads us to continuation vehicles.
Changing Sponsor Exit Paths
To recap, traditional exits include 1) sale to a strategic 2) sale to a sponsor (sponsor-to-sponsor trade) 3) IPO / secondary sell-down
These paths have since evolved.
Today, in addition to the above, exits come in the form of 4) minority / phased exit 5) de-SPAC 6) GP-Led secondary 7) IPO / Merger-sale 8) fund-level debt / “senior equity” take-out.
GP-led secondaries are particularly interesting.
Here’s what happens. The GP carves the investment out of a fund and places it into a new vehicle in which they will continue to manage the investment. Investors can roll into the new vehicle or elect for monetization at time of roll. The GPs can crystalize carry and backstop outgoing LPs with new LPs. The kicker: the GP resets their carry at time of the CV deal.
Let’s say the sponsor buys John’s Tires Company (JTC) in 2018 for $100. Through M&A and operating improvements, they’ve improved the business and have it marked at 2.0x in 2023 (original cost basis is 1.0x).
Today, at 2.0x, the JTC is worth $200. $100 of cost basis, $80 LP carry and $20 GP carry.
Now, let’s look at two scenarios: one in which the sponsor sells the business and the other in which they do a continuation vehicle... assume both result in 4.0x MOIC.
1) Sale: $100 cost + $240 LP carry + $60 GP carry = $400 total exit.
2) Continuation vehicle (CV): $180 cost + $144 LP carry + $40 GP rolled carry + $36 GP carry = $400 total exit
Takeaways:
GPs can earn incremental carry via a continuation vehicle compared to a traditional exit.
Additionally, the more upside there is between the current mark and future exit value the more a CV makes sense for the GP.
For underperforming assets, GPs have an incentive to exit via a CV at as low of a price as possible to maximize potential carry within the CV.
More to come on the CV front. I’ll leave it here for now.
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Until next time.
John Galt