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- Continuation Funds
Several prominent VC firms like Insight Partners and HV Capital have launched so-called continuation funds in the recent past.
About a week ago, I poked fun at Lightspeed's announcement on LinkedIn.
The truth is, I have never dealt with continuation funds and know very little about them. Something I wanted to change.
What is a continuation fund?
A continuation fund is a new investment vehicle set up to acquire a portion or the entirety of an existing fund's portfolio as it nears the end of its lifespan.
Both funds are typically managed by the same fund manager (General Partner, or short GP). That's why it's also called General Partner (GP)-led secondary transaction.
Investors (Limited Partners, or short LPs) in the original fund are given the option to either roll existing interests into the continuation fund or cash out.
Cash contributions from new investors to the continuation fund will be used to pay out the original fund investors that have opted to exit.
TL;DR:
New fund to acquire assets of an existing fund
Also called GP-led secondary transaction
What purpose do continuation funds serve?
Traditional VC funds typically have a limited lifespan of 8-10 years. Usually, there are predetermined extension periods, but they give GPs another 2-3 years max to sell the remaining assets.
If the end of the fund term falls in the worst M&A and IPO environment for over a decade (as is currently the case), this puts massive pressure on GPs.
That’s why many VC funds now consider selling their startup stakes to secondary buyers in order to return capital to their LPs.
While they are exploring all kinds of secondary options, continuation funds seem to be growing in popularity.
In the past, such vehicles were primarily part of private equity playbooks. They were seen as the last resort to manage non-performing assets of an otherwise successful fund.
In contrast, they are now used by VC firms to "reset the clock" and wait for a market recovery and/or extract further value from well-performing investments that have not yet reached their full potential.
TL;DR:
Extending holding period for selected portfolio companies
Providing liquidity to existing fund investors
Tapping additional commitments from new and rolling investors
Increase dry powder for follow-on / add-on investments
What are potential issues?
Setting up such a fund is costly – with complex tax and structural aspects to consider. That is why not many VC firms have yet ventured into it.
Another problem is the conflict of interest that will inevitably arise given that the GP will be on both sides of the transaction – with the duty to represent the interests of both existing investors and rolling / new investors.
A valuation discrepancy between what new investors are willing to pay and what existing investors think assets are worth might prevent transactions from happening.
Last but not least, the market for continuation funds is still undercapitalized. This means that the dry powder from secondary market buyers is not sufficient to satisfy the demand from GPs for new vehicles.
TL;DR:
Continuation funds are costly and complex to set up
Potential conflict of interest as GP is both “seller” and “buyer”
Not enough dry powder in secondary market to meet demand for new vehicles
Market and Trends
The secondaries market in general has grown substantially in recent years (to $112B in 2023).
While in 2016, GP-led transactions represented 24% ($9B) of the overall secondary market volume ($37B), they now account for almost half of it ($52B, 46%).
However, the statistics do not distinguish between PE and VC. From what I have read, it can be assumed that the VC share is still low, but increasing.
Curious to see whether continuation funds in the VC sector are just a short-term phenomenon until the market has stabilized, or whether they will be used more frequently in the future to extend the investment horizon of traditional VC funds.
PS: Experimenting with referrals for the first time. I would highly appreciate if you spread the word about my newsletter via the link below! 🙂
The person with the most referrals will receive a shout-out in the next newsletter. 📢