Trends in Secondaries Transactions and Continuation Funds

As market liquidity issues have slowed down fund exits, secondary transactions are experiencing unprecedented growth, with Limited Partners (LPs) seeking alternative liquidity routes. A significant driver of this trend is the rise of continuation funds. These funds are primarily General Partner (GP)-led secondary transactions, where a GP transfers portfolio assets from one fund to a new continuation fund managed by the same GP. This mechanism extends the period for which the GP can hold assets beyond the original fund's life, offering LPs the option to either exit or roll their exposure into the continuation fund. LPs choosing to exit are cashed out using proceeds from incoming LPs, often led by specialist secondaries funds. Additionally, LP-led secondaries, where investors sell their existing stakes in a fund to new investors with minimal GP involvement, are also gaining traction.

Factors Driving the Rise in Secondary Transactions

Several factors contribute to the increasing popularity of secondary transactions:

Lack of Traditional Exits: The anticipated interest rate cuts have been slower than some have expected, and the volume of IPOs and private market deals have stalled. These traditional exit routes for GPs have led to a backlog of unsold assets held by funds. In such scenarios, where GPs hold onto portfolio investments longer, secondary sales offer LPs a return of capital and greater flexibility in their investment programs.

Liquidity Needs: As LPs face challenges in realizing their investments, concerns over exits have intensified. Institutional investors, in particular, are looking for a return of capital. LPs often need to rebalance their holdings to comply with internal policies and commit capital to new vintage launches. Secondary transactions provide an early exit opportunity for LPs looking to realize profits and obtain a return on their capital sooner.

De-risking Portfolios: In uncertain economic times, LPs focus on de-risking their portfolios. Secondary transactions enable them to offload underperforming or non-core investments, thereby reducing risk exposure.

Hesitation with GP-led Solutions: GPs unable to sell underlying assets or raise new capital have turned to financing products like NAV lending facilities to fund distributions out of debt. While NAV financing can result in a quicker, less complex process than a full exit, LPs have increasingly questioned its efficacy. It can require LPs to hold and return distributions to repay the facility if assets are not realized at NAV. Similarly, GPs' use of dividend recapitalizations to return capital to investors has raised concerns, as it involves issuing debt over the underlying assets of a fund, potentially weakening their financial position.

Distributions In-Kind: Closed-ended fund agreements often permit GPs to distribute assets in-kind to LPs upon winding up. In the absence of other viable exit forms or when GPs are time-constrained during a fund's liquidation period, they may enforce this provision, distributing shares in investment holding companies or interests in underlying assets. For LPs unwilling or unable to hold direct assets, secondary sales offer a way to cash out before this risk materializes.

Emerging Trends and Structures

The lack of market liquidity and the targeting of a new class of investors, such as private wealth clients, have led to a significant increase in the use of evergreen funds. Traditionally available for liquid asset classes, these structures are now increasingly used by funds in credit, real estate, and private assets. While the illiquidity of underlying assets and the difficulty in monthly valuation pose risks, limited redemption cycles may provide a suitable path for investors needing urgent liquidity and wishing to avoid direct sales

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Brendan Gallen is a Partner at Reed Smith

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group