Venture investors are dealing with the same fund lifecycle challenges as private equity, so it’s not a surprise that they’re beginning to embrace similar strategies for dealing with assets that have gotten long in the tooth.
First reported last week by the FT, Lightspeed Venture Partners is now reaching out to investors to secure commitments for a new continuation fund, meant to buy out stakes held by existing Lightspeed funds in 10 of the firm’s portfolio companies.
The new fund, whose combined positions Lightspeed is valuing at around $1 billion, will allow limited partners the opportunity to cash out their current investment or roll their pro rata share into the new vehicle.
Much Needed Distributions
As funds age, venture investors are under pressure to provide cash distributions to their limited partners—particularly if they’re trying to raise capital for a new fund.
A slower market for M&A-led exits isn’t helping, but early-stage investors have been more impacted (relative to private equity) by last year’s closure of the IPO window. With just $87 billion of first-time issuer offerings coming to market, 2023 was the slowest year of IPO activity since the dot-com bubble burst in 2001. Public markets activity is now ramping back up, though new offerings remain well below prior levels.
That shouldn’t matter, says Lightspeed chief business officer Michael Romano. “We think VCs can’t just use the excuse that the IPO window is closed, they need to take a page out of the private equity playbook and build more consistent liquidity that LPs can count on.”
Same Thing, Different Considerations
The jump in popularity for continuation funds within private equity is well documented—the strategy accounted for around 80 percent of total sponsor-led secondary market transactions through the first half of 2023—up from just 41 percent in 2019.
They’re far less common, however, for venture investors.
Private equity sponsors generally point to their use of continuation funds as a strategy that’s as much about holding onto top-performing assets as it is providing LPs an opportunity for liquidity. If the gem of the portfolio has another five years of value creation ahead of it, why not keep it around? Less common is the retention of sub-par portfolio companies in the hope of future improvement in either performance or exit prospects.
Recent examples provide some support: Last year, TPG posted a 2.0x MOIC and more than 30 percent IRR on its single-asset continuation fund for Creative Artists Agency, and ArchiMED’s Polyplus continuation fund was said to have returned between 4.5 – 5.0x.
The strategy has also provided solid exits for current funds that are relinquishing their stakes: In December, AnaCap disclosed that its continuation fund-led exit provided a 3.5x MOIC and 52 percent IRR across two assets for its 2016 vintage AnaCap Financial Partners III.
A similar positive portrayal of continuation funds may be more challenging for venture. With its larger number of high-upside, relatively low-probability bets, the asset class may be structurally less likely to accommodate a successful continuation fund.
At the point in a fund’s lifecycle in which a continuation fund becomes a viable option, many portfolios may already have a clear separation between winners and losers. Some investments have wound down operations, while others are (hopefully) home runs. Less common is the more measured “middle of the road” trajectory.
Which selection of those various assets do you then decide to place into a continuation vehicle? This also presents a problem for LPs deciding whether to take the liquidity or roll their stake into the continuation fund. At that point, remaining invested in the new vehicle is a very different proposition than the original fund you signed up for.
Such a dynamic is not necessarily bad, though the decision to participate can be challenging in other ways. LPs must consider whether they’d prefer to lock up capital for another indeterminate amount of time or cash out in a deal that they might feel is being done at a valuation discount to a typically more competitive sale process or public offering.
For both venture and private equity investors, it’s a trend worth monitoring. The latest guidance from the Institutional Limited Partners Association warns members to incorporate questions related to continuation funds into their fund/manager diligence processes, and to scrutinize related language when negotiating LPAs and fund documents (particularly any terms that pre-clear potential GP conflicts of interest).