Continuation Funds Raise Questions About Valuation Risk in Pension Portfolios
As more GPs pursue continuation funds, institutional investors are faced with new questions about the overall risk levels in their portfolios.
Reported by Bailey McCann
A new dynamic in private equity — the continuation fund — could exacerbate governance and valuation questions that arise from existing valuation challenges related to private assets.
Over the past few years, the number of continuation funds in the market has steadily increased. According to law firm Dentons, continuation funds accounted for 50% of the $126 billion secondary market volume in 2021.
That number is only likely to grow. A report from PitchBook on private equity activity and performance in the year’s second quarter showed that exit activity has fallen “75% from peak to trough on a quarterly basis and shows no immediate signs of recovery.”
The PitchBook analysis showed that even if exit activity starts to rebound, it will take longer for private equity managers to realize the sale of their assets. A slower timeline for exits means that all assets are likely to be held longer than they have been in the past, and GPs will have to be very disciplined about when they exit their best portfolio companies.
PitchBook explained that, “while the assets purchased five years or more ago are slightly ahead of the game, thanks to the impressive boost in exits seen in 2021, the industry now faces a growing maturity wall as exits have slowed to a crawl and funds draw closer to their end dates.”
Continuation funds can bridge the gap for some of the best portfolio companies, but it is a solution that comes with trade-offs.
Continuation funds are typically single-asset funds that private equity managers use to maintain a stake in an investment that would otherwise be at the end of its life cycle. They also establish a valuation for that asset when it gets moved over into the new fund. The beneficial economics for the private equity manager are relatively clear: They keep a prime asset and, in many cases, will realize their payday from carried interest when they switch the asset over to the new vehicle.
Investors have two options when presented with a continuation vehicle: roll over into the new single-asset fund, often with additional promised capital commitments required, or cash out. The benefits of rolling over, however, are not usually that obvious.
Risk Gets Riskier
In July, the Equable Institute released its latest report on the state of public pension funds. The report looks at funded status, investment assumptions and performance potential, and the institute did not like what it found.A particularly notable section on public pension investment assumptions argued that pension funds are “addicted to risk”—a heavy sentence for a group of fiduciaries. According to the report, while pensions have somewhat steadily revised down their return assumptions, many could not achieve a 6% return with a mix of listed equities and bonds. As a result, pensions are increasing their allocations to private markets to make up the difference, and cracks are beginning to show.
Allocations to private equity, private real estate and infrastructure embed a certain level of asset risk into public pension portfolios, even if a pension fund is just invested in a commingled fund. As an investor, pension funds are waiting on the investment return from exits on the assets in those funds.
Equable noted that pensions also now face an additional type of risk: valuation risk. Because pension funds set contribution rates on the reported value of assets in their portfolio, this calculation depends on the accuracy of “fair price” valuations.
According to the report, “roughly one-third of the $4.8 trillion in assets that pension funds reported having in 2022 was based entirely on nontransparent valuation approaches from asset managers (not market-based prices like stocks). If these valuations are off, then today’s contribution rates have been miscalculated.”
As CIO has previously reported, there is a bit of a symbiotic relationship between pension funds and asset managers here. During market volatility, opaque valuations that can be smoothed out over time might give pensions a little headroom on their performance reporting. But according to Equable’s report, “the share of pension fund assets with ‘ valuation risk’ has more than tripled since” the financial crisis of 2008 through 2009.
On its face, this statistic raises a number of obvious governance questions. But a new dynamic in private equity in particular could exacerbate pension risk if it is not watched closely.
Fair Value Raises Fiduciary and Governance Questions
Guidance from the Institutional Limited Partners Association calls on private equity managers to increase transparency and make the process more straightforward overall. But Edward Klees, a partner in the investment management group at law firm Reed Smith, is not seeing that happen yet, and he says the way continuation funds are being offered makes it almost impossible to suss out fair value.“Usually we get short notice, and it’s not easy,” he says. “It’s maybe two days to examine hundreds of pages of new documentation and try to make a determination.
That is likely why, according to a recent report from Bain & Co., “when asked in a recent survey if liquidity concerns left them more inclined to cash out of a hypothetical investment or roll it over into a [general partner] -led secondary, approximately 60% of LPs said they’d take the cash.”
Klees says continuation vehicles have an embedded asymmetry that investors should scrutinize closely. “GPs typically get to crystalize their carry as though it was any other sale, but LPs have to reinvest or maybe cash out based on what they can assess at the time,” Klees says. “There is also often no requirement for a minimum disclosure of conflicts, and while the SEC wants investors to get a fairness opinion, I think investors wonder how much a fairness opinion will help. So there are a number of governance concerns.”
Klees points out that the question of fairness could be hard for anyone to answer adequately. “When we think about what ‘the market’ is, that is a nebulous term, especially in private assets,” he explains. “There is such a dense concentration of law firms representing general partners in private equity, you could make the argument that if they have a perspective, they can peg that as [the] market. So then you try to fall back on what’s fair, but here, there is already an asymmetric structure.”
Questions of fairness could also arise about the size and scope of LPs. Larger investors, with embedded deal teams, may be able to more easily react to a 48-hour timeline for committing to a continuation fund. But it is unlikely small- and medium-sized institutions are going to have the same resources at hand.
David Swanson, managing director at secondaries focused firm Kline Hill Partners notes that there is a shortage of people able to evaluate continuation vehicles across the industry on both the GP and LP sides, as well as from service providers. “The high volume of deals can be overwhelming for some. Groups have different timeline sensitivities, different liquidity sensitivities,” he says. “So investors have to evaluate each of those issues for themselves, across multiple deals at a time.”
Uncertain Performance
Expected performance is also unclear. According to both the Equable report and recent performance reporting from CalPERs, private equity returns for this year are likely to be flat at best. Because private equity returns lag, it is unclear how long flat returns could be a feature of private equity performance.Many continuation vehicles are so new they have not yet reached their exits, so investors can not readily look to prior fund activity to establish likely performance.
Kline Hill’s Swanson argues that the popularity of GP-led secondaries deals suggests a level of comfort on the part of at least some investors. “In many cases, the assets are four-plus years old,” Swanson says. “Continuation funds give the more duration-sensitive LPs the option to take liquidity, while those comfortable with longer hold periods can stay in the companies for longer. Ultimately, LPAC sign-off is needed for a GP-led transaction to move forward.”
Still, if private equity performance is beginning to falter in this market, that could put downward valuation pressure on the so-called premium assets that private equity managers put into these funds, making it even harder to game out expected returns.
PitchBook data showed that private equity fundraising is also starting to lag in this environment. Industry analysts expected a slowdown, given the fundraising records reached in 2022, combined with institutional LPs still dealing with the denominator effect in their portfolios, which limits how much they can reinvest. However, if the current performance lag lasts, that is likely to put more pressure on the fundraising environment.
Fundraising activity in the first half of the year is 15% to 25% slower than last year’s pace, based on the number of funds closed and final amounts of those closed funds, according to PitchBook.
So what does this have to do with continuation funds? Investors in those funds are investing capital with private equity sponsors through the new vehicle without a clear picture of expected performance in an environment with many emerging headwinds. The next few years are shaping up to be an experiment about how well portfolio smoothing actually works.