What do continuation vehicles mean for management teams?
Like many aspects of business, and indeed life more generally, the private equity world is great at finding innovative ways to evolve and “creative” new names to label these evolutionary changes.
The continuation vehicle (“CV”) is one such change and, for these purposes, is used to describe any fund to find transfer where the same private equity house (General Partner or “GP”) retains a significant, usually controlling, shareholding in the underlying business.
Whilst not a new phenomenon it is clear that the CV has become more prominent in the past few years. There are a number of reasons for this but the principal driver is the fact that the GP feels there is a lot more value to be gained by continuing to support a business than by selling a controlling stake in the business. Sometimes this is because the hold period has been longer than expected and now is not the right time to sell whereas the GP needs to wind up the fund in which the investment sits. In other circumstances it is simply that the business has performed very strongly and the relationship between the GP and management is excellent and they want to continue to work together to deliver on the strategic plans for the business.
The only other point to note about continuation vehicles is that in the opaque world of private equity these transactions tend to be at the more secretive end of the spectrum!
So what do CV transactions mean for management teams and what are the key issues to think about?
Is a CV transaction treated as an Exit for managers? – in theory this will be a matter of fact in the drafting of the existing Investment Agreement and / or Articles of Association. Going back 3 – 5 years it is unlikely that the concept of a CV transaction would have been specifically addressed but the general provisions around exit may well cover the circumstances of a CV and allow investors and managers to understand the legal position. In practice we see most CV transactions treated as an exit for managers, allowing them to cash out a proportion of their value, convert the balance into a co-investment strip alongside the investors and then negotiate a new management incentive programme (“MIP”) to motivate and incentivise the team for the next phase of the growth story. There are two compelling reasons for this approach; first, the CV provides liquidity to the existing investors in the fund and almost certainly enables carry payments to be made to the GP and secondly, the management team have performed well and hence the investors want them to feel good about the CV transaction. The investors self-evidently want to support them to deliver future returns so it makes perfect sense to provide some liquidity to management teams and re-set the risk reward balance for high performing managers.
Valuation of the business going into the CV – this is always going to be a sensitive area for all parties involved in a CV transaction. For the existing LP investors (particularly those fully exiting at the time of the deal) it is imperative that they have comfort that the CV transaction is being completed at market value. This is also in management’s interests so there should be alignment of interests here. A new, independent, third party investor coming into the deal alongside funds managed by the existing private equity house is often seen as the best indicator of market value being achieved and hence the reason why this can be seen in many CV transactions.
Exit timing – a key consideration for management teams in CV transactions is the impact on ultimate exit timing. If a CV transaction takes place after a significant hold period then it is likely that a full exit will be another 3 – 5 years away. This has implications for succession planning within the management team, makes gaining liquidity at the time of the CV transaction even more important and may require more significant strategic planning updates; it is often the case that a CV transaction unlocks further capital which can drive accelerated growth plans – both organic and inorganic.
New MIP economics – agreeing a new MIP scheme will be a critical part of the CV process. This can be tricky given the embedded relationships between managers and investors which is why we are often asked to advise on market metrics and help management teams achieve market facing terms. Our involvement opens up access to much wider market metrics in the value range for the CV transaction and, importantly, can allow managers to remain one step removed from negotiations with their investors who are also fellow Board members.
Tag along rights – making sure that the new investment agreement documentation covers off the implications of a further CV transaction is also important. We find that investors are balanced in their approach to this as they understand that management team members get involved in private equity transactions (at least partly) because they give the potential for cash capital gains over a 3 – 5 year period. Effectively the inherent assumption is that investors and managers want to secure great exits together. The increase in CV transactions has highlighted the possibility of investors gaining exits without triggering liquidity for managers and hence carefully drafted Tag Along rights will put managers minds at rest and give assurance that if investors get cash out, managers should expect the same.
More to come? – It is difficult to see fund to fund transfers becoming a very significant part of the private equity landscape. The circumstances in which they can be justified to LPs are likely to remain relatively limited and the feeling is that LPs are inherently sceptical about the potential for conflicts of interest. In most cases where the existing private equity sponsor wants to continue to have exposure to a high performing business and management team post exit, this can be achieved by retaining a stake or investing in a minority position behind a new majority shareholder. Where a controlling interest sale process has delivered clear evidence of current market value this is seen as more comforting to LPs. We have seen many more cases of retained stake transactions than continuation vehicles.