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PE Fundraising

Why secondary buyers prefer mid-market continuation funds

The middle market has become a sweet spot for continuation fund investors.

Not all investors believe bigger is better, especially those shopping for continuation funds.

The middle market became a sweet spot last year for these vehicles, which allow GPs to extend the holding period for select portfolio companies and return liquidity to their limited partners.

The number of middle-market continuation funds increased in 2023, in tandem with a decrease in the check amounts that secondary buyers wrote to continuation vehicles, according to a report from Lazard.

GPs use continuation vehicles to roll over one or multiple portfolio companies into a new fund. A Jefferies report on the secondaries market found that the ‘vast majority’ of single-asset continuation funds closed in 2023 were middle-market vehicles.

Exit mechanisms

The popularity of middle-market continuation vehicles, defined as those falling below $1 billion in size, can be attributed to several factors. One is the availability of a versatile set of exit mechanisms for smaller assets.

“One of the drawbacks of executing at the largest end of the buyout market is you may start to limit yourself in terms of the different avenues for ultimate exit,” said Jeffrey Keay, a secondaries-focused managing director at HarbourVest. “You may be more reliant on the public markets, which at the moment aren’t terribly healthy, as a path for getting liquidity.”

On the flip side, PE firms at the largest end of the market might have more established teams, deeper resources and better access to capital markets compared to smaller GPs, Keay said, making it beneficial for buyers to also maintain an exposure to large deals.

Overall, the quality of the assets and the profile of the GP, as well as the alignment of interests in the transaction, drive commitment decisions, he added.

Smaller bites

Another draw of middle-market continuation funds is that they typically require fewer commitments to close.

The bulk of secondary buyers will not write checks of more than $300 million to finance a single-asset fund, industry participants said.

With a focus on diversification, these investors wish to avoid too much exposure to any one company. That’s why even the largest secondary buyers rarely invest more than $300 million into a single-asset deal, even when they have a large war chest, said Houlihan Lokey head of secondaries Sameer Shamsi.

Secondaries buyers willing to independently foot the bill for a multimillion-dollar deal—or even a billion-dollar deal—are in the minority. However, London-based asset manager Intermediate Capital Group is one of them.

For instance, ICG acted as the lead buyer in 2021 for Clearlake’s $2 billion single-asset continuation fund backing software portfolio company DigiCertwith a commitment of $1 billion, according to PE Hub. ICG also backed New Mountain Capital‘s continuation fund for medical data company Datavant, which was expected to close at over $1.1 billion, Secondaries Investor reported in October.

But most secondary buyers are cautious about deploying capital.

Lazard’s report shows that both lead and other participating buyers, known as syndicate investors, lowered their commitments to continuation funds last year.

In 2021, 50% of lead investors in continuation funds reported an average commitment size above $100 million, according to the report. That dropped to about 28% in 2023. For syndicate investors, nearly 30% committed an average ticket size of more than $50 million in 2021, compared with only 8% last year.

If a single-asset continuation fund requires $1 billion in new capital, it is typically syndicated to a group of investors—in some cases up to a dozen. Consequently, buyers must consider the syndication risk when evaluating most large continuation funds.

“Once you get to a billion-dollar single-asset deal, I think the continuation fund has to be a very high-quality asset at a very attractive price. Otherwise, it’s going to be hard to raise enough capital to complete that deal,” Shamsi said.

Steady demand

The market for continuation funds is still undercapitalized, which means the dry powder held by secondary buyers cannot satisfy the pent-up demand from GPs to launch new vehicles. Therefore, secondary investors can afford to be very selective.

Some dealmakers are hopeful that the substantial dry powder accumulated by secondary firms last year will reduce syndication burdens for large transactions.

Rich Saltzman, a managing director at Jefferies’ private capital advisory group, said he expects more single-asset large continuation funds will close in 2024 as these buyers open their wallets to pursue bigger opportunities.

“The syndication time frames will be reduced because there’s more capital available to capitalize these billion-dollar-plus transactions.”

Featured image by FabrikaCr/Getty Images

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