Continuation Funds: East Africa’s Private Equity Exit Solution
The Exit Problem: A Lurking Peril
For as long as private capital arrangements have existed across the East African region, one major peril has been lurking in the shadows, giving Private Equity (PE) fund managers nightmares: the exit problem. The muted exit environment in which PE funds in the region operate is largely attributed to the poor performance of the capital markets which limits the volume and value of IPOs which would, otherwise, be the most profitable exit strategy. As a result, funds have only been left with trade sales, secondary buyouts and management buyouts upon the expiration of their commitment period. These options are resource and time-intensive to pursue and even then, rarely crystallise into exits for investors (when they do, their profitability could be better).
A deep dive into the metrics indicates that over the past decade, there have only been 51 exits out of 427 investments. 2022 recorded an all-time high in the volume of exits with Kenya leading the region, and Uganda, Rwanda, Tanzania and Ethiopia following respectively. In 2023, only 7 PE exits valued at USD 1bn were recorded down from the 8 recorded in 2022. The buyer profile for exited assets generally comprised a mix of secondary buyouts (42.8%), trade sales (28.6%) and a combination of the two (28.6%). There is an unsurprising absence of IPOs. Since PE funds invest and operate businesses to exit, the muted exit environment has discouraged initial investments in the region where a viable path to exit is unavailable.
These clear signs of poor exit performance show that a lot of money is stuck in funds because investors are not leaving within the agreed time. If we can free up this capital, fund managers could potentially utilise it for new investments within the region. This, in turn, could drive growth across sectors and profitability for investors which would greatly improve the investment profile of the region.
A Solution: Continuation Funds
A possible remedy to the exit debacle is Continuation Funds. By definition, continuation funds are new fund vehicles established to acquire one or more assets from a legacy fund. The assets continue to be managed by the same General Partner (GP) or fund manager. These funds are typically set up for a shorter period than the usual 10-year lifespan of a legacy fund (up to 6-7 years). Upon the formation of a continuation fund by GPs, LPs of the legacy fund have three major options at their disposal: (a) selling their interest in the existing fund and receiving a pro-rata share of the purchase price; (b) rolling their interest from the legacy fund into the continuation fund; or (c) in some cases both. With regard to rolling over their interest, LPs may take two major courses of action: a status quo basis, and a reset basis.
Under the status quo basis, assets are transferred from a legacy fund to a new fund without changing the fund terms. LPs requesting the status quo basis desire an option closest to the “pure” status quo with specific criteria, including no increase in the management fee and the carried interest rate, no decrease in the preferred return hurdle or other GP-favourable changes to the distribution waterfall, no crystallisation of carried interest of rolling LPs, and rolling LPs’ side letters to apply when relevant.
With the reset basis, GPs accept LP participation in the continuation fund on new economic terms and lock its carried interest. Moreover, the GP may request that rolling investors provide additional capital commitments to the fund, offering new terms to the GPs such as modified carried interest and management fees. In Figure 1 below, a continuation fund structure is illustrated.
Why you Should Consider Continuation Funds
The main justification for the growing GP gravitation towards continuation funds, at least at a global scale, is that they can generate higher value beyond a legacy fund’s commitment period. Moreover, portfolio companies which would otherwise have great performances (trophy assets) may underperform in the short term but can create significant value for the LPs in the long term, beyond the fund’s stipulated lifespan. In addition, negative macroeconomic trends may affect the exit decisions of LPs, and as such, traditional exit options may not be viable in such markets. By far, this is the biggest impediment to exits in the East African region.
Secondly, continuation funds offer an opportunity for capital infusion. This is particularly premised on two inevitable occurrences in the legacy fund arrangement. Firstly, towards the end of a fund’s commitment period, capital is withdrawn leaving portfolio companies in need of surplus funding with limited options. Secondly, early in the fund’s lifecycle, assets may experience spontaneous growth, requiring additional funding to support their expansion. This is primarily because an extension of the original fund does not include raising additional capital and if needed, requires the consent of all LPs. Each LP may have different liquidity needs therefore making a legacy fund the most unfavourable option to GPs in the circumstances.
Thirdly, continuation fund structures offer optionality to GPs. GPs now have the option to hold onto trophy assets led by management teams they are conversant with rather than adapt to new boards of directors during difficult dealmaking conditions with cutthroat competition and enormous levels of dry powder. This is because the continuation fund structure eliminates the need to sell the assets to another PE fund thereby eliminating the need to restructure the portfolio companies.
Another reason for continuation funds is their immense benefit to the legacy fund’s LPs. Faced with the choice of either taking liquidity by realising gains from the assets managed in the legacy fund by the GP or rolling them into the continuation funds, LPs who choose the latter enjoy prolonged exposure to familiar assets which could in turn prove to be trophy assets and hence strengthen their relationships with the GPs. Furthermore, continuation funds also offer a golden chance to incoming LPs to invest in more mature assets over a shorter period than the portfolio company’s life cycle thus allowing incoming LPs to have a clearer perspective of the assets they are investing into and build a firm relationship with the GPs.
A Case for East Africa
Across the East African Private Capital industry, there is no single precedent of a continuation fund structure being deployed by GPs of a legacy fund. This could largely be attributed to the uncertainty of the PE cycles across the region and the fact that there are roughly two exits per quarter, a clear depiction of the paltry exit activity within the region. This is majorly attributed to several factors key among which are an unpredictable macroeconomic environment and the illiquidity in our capital markets to facilitate IPOs in the region.
East African GPs need to be deliberate in implementing the continuation fund structures. The unique structure of continuation funds means that fund managers run the risk of perceived conflicts of interest. This is because they will sit on the buy-side (continuation fund) and sell-side (legacy fund). Conflicts will often relate to issues such as the pricing of the assets and the motivations for a sale in some instances. However, to eradicate these conflicts, the LP Advisory Committee, which reviews these conflicts, should ensure a fair and transparent process for existing investors in the fund. In doing so, it is incumbent upon the GP to identify potential conflicts quickly, find mitigation strategies and refer them to the LP Advisory Committee for approval. Any conflicts related to the process of the transaction should be identified, mitigated by the GP and approved by the LP Advisory Committee as and when they arise during the transaction.
Still, at a global scale, continuation funds have become normalised as viable alternatives to traditional exit routes and liquidity. In 2021 for example, advisory firm Lazard reported that such GP-led deals accounted for 50% of the USD 126bn total secondary market volume and that 83% of this was in continuation funds, either single- or multi-asset vehicles. A study carried out by Numis found that continuation funds were preferred over dual-track processes, IPOs and private auctions. As of 2022, the GP-led transaction volume had reached USD 52 bn doubling its volume size from 2020. Considering the increasingly uncertain times the world has faced over the last five years, this dramatic increase in the transaction volume of continuation funds indicates that they have played a crucial role in reconciling negative investor outlooks and the need to allocate dry powder in the private equity industry. The liquidity provided has enhanced investor confidence in private equity funds leading to smoother capital raises even during difficult macroeconomic conditions.
The existence of continuation funds has also led to an increase in the focus on value investing because GPs can assess potential investments on their fundamentals and can utilise the option of rolling over assets that still have tremendous growth potential into the continuation fund. For East Africa which has in the last decade had approximately 255 private equity investments and only about 100 announced exits, the uptake in continuation funds and its growing popularity could not have come at a better time.
Conclusion
In conclusion, having demonstrated the viability of Continuation Funds, these GP-led deals provide a solution to the region’s market volatility and high inflation rates. GPs in the East African region are implored to embrace this new solution because it provides a win-win solution for both GPs & LPs as they have the benefit of optionality and for investors to continue benefiting from the trophy asset long after the commitment period which boosts their return on investment and creates the incentive for reinvestment in East Africa-focused funds.
