Buying Time: Continuation Funds Easing Private Equity Exits

Huge sums of private capital have been invested onshore since the beginning of the shale boom. Since 2015, $327 billion has been invested in 1,844 deals across all segments of the U.S. oil and gas sector, according to analyst reports. Nearly two-thirds of that total was deployed from 2015 to 2019.

While the volume of activity has been strong, the data point on timing is the most telling. Typical private equity funds have a 10-year lifetime, with the possibility of a couple one-year extensions. That means the clock is running out on vast swaths of investments.

Limited partners (LPs) that provided the capital for those deals fully expect private equity general partners (GPs) to get their money back—and then some. The torrid pace of deal activity in recent years has certainly helped, but plenty of assets remain out there.

So, what is private equity to do?

Arrows in the quiver

There has been a generalized shift in the way private equity firms have structured exits for their portfolio companies, Robert Seber, partner in Vinson & Elkins’ private equity practice, told Hart Energy. Whereas M&A and IPOs were the predominant paths to exit in the past, a third option has rapidly emerged: continuation funds.

In essence, continuation funds are specialized funds created by private equity firms to extend the deadline for when a portfolio company needs to exit. They go by many names. They are also known as continuation vehicles, CVs in industry parlance, or, for those who favor arcane terms, general partner-led secondaries.

Their rise has been driven by several factors, said Phillip Gayle, founder and managing partner of Andros Capital Partners. Many considerations are structural, such as timing considerations relating to fund life. Other factors may be more specific, such as the private equity sponsor or management team’s desire to continue owning or managing a particular portfolio company, he said.

Continuation funds are just one tool in the toolbox for private equity general partners (GPs) to consider when evaluating when and how to exit investments, Gayle said—particularly for larger portfolio investments given the lack of a healthy IPO market in recent years.

“CV’s can be a good way to let a winner run even if other factors within your existing structure may be prompting you to consider an exit,” he said.

In 2023, Andros Capital closed Andros Energy Capital II at a $750 million hard cap. The new fund targeted middle-market transactions valued between $100 million and $500 million and would maintain a “completely flexible and opportunistic investment mandate.”

Gayle declined to discuss specific transactions. Generally, the firm’s CV investments are motivated by a desire to own companies in partnership with high quality general partners and talented management teams that have built businesses difficult to replicate. “And we’re willing to embrace structural complexity in order to accomplish that,” he said.

Early in 2024, Andros Capital invested in a $1.6 billion continuation fund by Quantum Capital Group. The CV was created to buy out Quantum’s stake in Appalachian-focused HG Energy at an enterprise value of $1.9 billion. Elliott Investment Management reportedly committed more than $500 million to the CV and was joined by private equity firm Andros Capital.

CrownRock case study

Whatever name they go by, it’s clear continuation funds have risen in prominence.

Continuation vehicles have eclipsed IPOs as a preferred exit strategy, said Seber.  “Continuation funds have definitely become a very accepted form of exit for private equity funds,” he added.

But that wasn’t always the case.

One of the first continuation funds to really grab attention in the oil and gas sector was a 2018 Lime Rock Partners’ vehicle, Seber said. “Everybody in the industry was looking at it and asking, ‘How can we do this?’”

Lime Rock Partners IV AF Acquisition Fund closed in June 2018 at $1.9 billion. The lead outside investor was HarbourVest, but Lime Rock employees constituted the single largest investor in the fund. All limited partners had the option to reinvest in the acquisition fund or receive full or partial liquidity.

The CV acquired all the remaining assets from the 2006 vintage Lime Rock Partners IV. The majority of the fund’s asset value was a controlling interest in Midland-based CrownRock. The company had been formed in 2007 and, by 2018, had 90,000 operated acres in the core of the Midland Basin with 40,000 boe/d of production, the firm said.

In 2021, Lime Rock closed a separate $203 million continuation fund to acquire assets connected to CrownRock Minerals from Lime Rock Partners VI, a 2013 vintage fund. Goldman Sachs was a major investor in the continuation fund.

The continuation fund strategy paid off handsomely in August when CrownRock completed its sale to Occidental Petroleum for $12.4 billion—17 years after the initial investment. In the intervening years, the company boosted its production to 170,000 boe/d.

Lime Rock grossed 79 times its $96.5 million investment in CrownRock, making it one of the highest returning investments—not just in the natural resources space—but across any private equity segment. CF Private Equity, formerly known as Commonfund Capital, was one of the limited partners investing alongside HarbourVest Partners in the 2018 continuation fund, according to the company.

Growing trend

Continuation funds have been growing in number and scale across the private equity sector globally. Private equity breaks down into two types of investments: primary and secondary.

Primary investments involve direct investment in a portfolio company by a GP, the private equity firm, using capital provided by limited partners LPs through the purchase of equity or credit. Secondary deals, however, involve the reselling of that primary investment by either the GP or LP.

The private equity secondary market has been steadily growing. Since 2018, global secondary volume has risen from $74 billion across all sectors to a projected $140 billion for 2024, according to Jefferies.

Relative to primary investments, however, the secondaries market is not large. Bain Capital notes that secondaries pale in comparison to the full scale of the private equity market, which it estimates to hold $20 trillion globally in assets under management.

Historically, LPs have tapped the secondary market to sell off stakes held in various funds. Such transactions are called LP-led secondaries. What has changed is that GPs are increasingly utilizing the secondaries market to create liquidity for their investors, which are known as GP-led secondaries.

GP-led secondaries grew 56% year-over-year between the first half of 2023 and the first half of 2024, the Jefferies report showed.

Such deals represented 41% of all secondary deal volume in the first half of 2024. Continuation funds make up the primary strategy utilized in GP-led secondaries, reaching 90% of all such deals in the first half of 2024. Continuation funds now constitute 14% of global private equity sponsor-backed exit volume.

Investor perspective

A major driver of continuation fund decisions is the strategy of its limited partners, John Grand, partner in private equity and M&A at Vinson & Elkins, told Hart Energy. LPs exert pressure on private equity firms to return their capital, he said.

Existing LPs already invested in a portfolio company have a separate and distinct point of view compared to LPs seeking to invest through a continuation fund, Seber said. Existing LPs have “not been too fond” of CVs and have started to “tighten the screws” on procedures surrounding continuation deals.

Part of the reason stems from the concern by existing LPs that assets put into a continuation fund are sold at discount to attract new investors, Seber said. The percentage of existing LPs that rollover to the continuation fund is “relatively low,” he noted.

To address these concerns, the Institutional Limited Partners Association has put out guidelines on continuation funds, said Seber. Limited partners have begun negotiating terms related to potential future continuation vehicles at the fund formation stage, such as requirements to explain the rationale for a possible CV or ensuring processes are being undertaken to maximize value, he said.

On the flip side of the coin, however, limited partners in the continuation funds themselves see the vehicles as attractive opportunities. Although private equity fundraising has generally been down, continuation fund formation has been “booming,”Seber said.

The terms GPs offer vary, but are generally favorable, said Andros Capital’s Gayle. “We’ve seen terms all over the board but, in general, we’ve seen overall incentive fee structures compressed in CV transactions relative to the fee structure of the existing underlying fund and portfolio company.”

Continuation funds are complex transactions that require “patience and finesse” to complete, he added.

Relative to other sectors, investor interest in oil and gas continuation funds has been somewhat delayed, he said. He attributed that delay to ESG, which has generally dampened the appetite for such investments. As the ESG movement has slowed down, Seber said there’s greater interest from investors in the oil and gas sector, enabling continuation funds.

Most of the interest has been in the upstream space, likely because the opportunities are larger, he said.

Non-upstream CVs

Within the upstream space, Lime Rock and Quantum Capital have both raised sizable continuation funds. But the trend extends to other segments, including midstream and oilfield services.

In January 2023, ArcLight Capital Partners announced the close of ArcLight 3C SPV with $407 million in capital commitments. The fund acquired a 25.1% interest in Third Coast Midstream from ArcLight’s Fund V. Third Coast is a U.S. Gulf Coast and Gulf of Mexico infrastructure asset focused on serving eastern deepwater and shallow water Gulf of Mexico producers.

In September 2023, Global Energy Capital, or GEC, announced completion of a $215 million single asset continuation fund focused on its portfolio company Estis Compression Solutions. The company is a high-pressure gas lift company acquired by GEC in 2019. Kline Hill Partners was the lead on the continuation fund.

In September, Amberjack Capital Partners formed a $200 million multi-asset continuation vehicle for eight assets from two legacy funds. BlackRock, Banner Ridge, LSV Advisors and Goldman Sachs were co-lead investors in the continuation fund.

Multiple considerations

While Lime Rock appears to be an outstanding example of what continuation funds can achieve, the vehicles present a multifaceted set of issues to overcome.

CVs fall into two distinct types, said Vinson & Elkins’ Grand. The first bucket includes portfolio assets where private equity sees“real upside”but the fund is reaching the end of its life. The continuation fund provides more runway to reach full potential valuation.

The second bucket includes assets located in basins that have fallen out of favor and require more time to become attractive to investors again, Grand said.

Deal activity, driven by public companies, has been heavily weighted toward the Tier 1 acreage in the Permian Basin, he noted. The thinking is that it will take many years for that acreage to be built out, but when that happens, publics will turn to Tier 2 opportunities. A CV can give a portfolio company the time and space to see that investment thesis to its conclusion.

Quantum Capital was seeking a $1.6 billion continuation fund to buy out its stake in Appalachian-focused HG Energy with an enterprise value of $1.9 billion, according to a March 2024 report. Elliott Investment Management reportedly committed more than $500 million to the CV and was joined by private equity firm Andros Capital, the company said.

Another consideration is whether a private equity sponsor is looking to exit a single asset or an entire portfolio, Seber said. Finding a buyer for a portfolio of assets may be more challenging. In this instance, a continuation fund represents the best option.

Continuation funds are formed with either a single asset or multi-asset focus. In the first half of 2024, 64% of all continuation funds had a single-asset focus, according to a report by Jefferies.

In December, Warburg Pincus announced a $2.2 billion multi-asset continuation fund with backing from HarbourVest Partners, France-based Ardian and the Canada Pension Plan Investment Board (CPPIB). CPPIB has been an active investor in the oil and gas space, and HarbourVest was lead investor in Lime Rock’s successful continuation vehicle.

Private equity firms are not being forced into continuation funds but actually elect them, Seber noted. Continuation funds enable PE firms to retain assets under management, he said, which is important in a fee-driven business.

At the end of the day, Andros Capital’s Gayle says continuation funds put “the choice of whether to sell or roll in the hands of each investor, which is a nice feature of CV’s that wouldn’t exist in a typical portfolio investment exit.”

Investors respond

The Institutional Limited Partners Association has nearly 600 members representing more than $2 trillion of private equity assets under management. The association’s guidelines related to continuation funds point out the flexibility provided by the structure to private equity firms, but also that continuation funds “are conflicted by nature, with the GP sitting on both sides of the transaction.” Additionally, continuation vehicles require LPs to make investment decisions about individual assets rather than PE funds or managers, sometimes under short timeframes.

The guidelines suggest that general principles regarding continuation funds are that they should maximize value for existing LPs. Limited partners rolling over into the continuation fund should be no worse off than if a transaction had occurred. LPs should have no less than 30 calendar days or 20 business days to make a rollover or sell decision.

Additionally, the private equity firm should present a rationale for a continuation fund transaction and should have already explored alternative options for the asset being considered, the association said.

And a competitive process should be undertaken to ensure a fair price was obtained and the process should include a third-party validation. An experienced adviser should be selected by the private equity firm. The limited partners should review the adviser selection and have access to the adviser throughout the process.