E216: How the $100 Billion Continuation Vehicle Trend Is Changing Private Equity

0:00HEC has done the most comprehensive study that I've seen, and they've collected data on 300 CVs, and these are CVs that were created from 2018 to 2023. And what they found, the bottom line is that CVs had a higher return than buyouts of similar vintage years. They had a higher DPI, so they delivered cash back to investors more quickly than buyouts, and they had a lower dispersion of returns. so they're less risky than the buyouts. Welcome to the How I Invest podcast, where we explore how top institutional investors make their very best investment decisions. Today, I'm speaking with Paul Cohen, Managing Partner at Agility Equity Partners, where he leads investments across the private equity landscape with a focus on the fast-growing continuation vehicle and independent sponsor market.

0:54We dig into the explosive growth of the CV market, the institutionalization of independent sponsors, and the overlooked opportunities in the lower middle market. Without further ado, here's my conversation with Paul. So tell me about the size of the CV or continuation vehicle market today. So the size of the market in 2024 was$70 billion. And to put that in perspective, the size 10 years ago was$7 billion. So it's just been growing dramatically. From my understanding, the continuation vehicle market grew 30 % in the first half of this year. Tell me about that and give me some numbers on that. Yeah, that's right.

1:35So it grew 30 % the first half of 25 versus 24. So it's grown to about$50 billion this year versus 31 last year. So it's on pace to hit$100 billion versus 70 last year. It still continues to grow. So interestingly, versus buyouts, the amount of if you measure the amount of dry powder to deals done and buyouts, it's about kind of four to one. And if you look at it for secondaries and we don't have it specifically for CVs, it's close to one to one. So the market's been growing as fast or faster than capital coming into it. It's really a capital constrained market. that's one of the concerns in the market right now is there's no dpi in large buyouts and that there's too much capital going after too few opportunities in fact i just spoke to a fairly large cio and he mentioned that they expect the investment period for large buyouts to be closer to four to five years and just to give you context in 2021 it was 18 to 24 months wow yeah managers even though they have a very strong incentive to deploy and to raise more funds and to show that they were working for their management fees, they still are taking a long time to deploy in large buyout.

2:50Yeah. And if you look at the DPI, the cash coming back to investors since really the 2018 vintage, it's been really low. There's been a famine. And just taking a step back, how would you go about simply explaining what a continuation vehicle is? We've sized the market. So I guess it does make sense to explain what the heck we're talking about. So continuation vehicle, the easiest way to explain it is just to use an example because it's a little esoteric. So I'm going to use an example of a KKR fund. I'm making this up. It's not actual. But say KKR, a buyout fund, has a great company that they invested in three or four years ago.

3:35The company has performed really well and might be their best company in their portfolio. and rather than sell it to another private equity fund or strategic investor, they like the opportunity to play forward a company they know well. So what they do is they capitalize a new vehicle, the continuation vehicle, which is a limited partnership just like theirs, and they're the GP of that vehicle. They raise capital from institutions like Agility Equity Partners, my firm, to buy their company from their fund. So it is an acquisition. They are selling their company out of the existing KKR fund to this new single asset entity that's going to hold the company capitalized by new investors like Agility Equity Partners to enable them to continue to own that company and to benefit from its growth.

4:37Tell me about what the incentives for somebody like a KKR would be to hold that asset in their current fund, and what are the incentives for those partners to now sell it to a continuation vehicle? To start with, KKR is kind of at an inflection point where they can't hold it in the current fund and continue to grow it. So the fund may be at its fifth, sixth, seventh year. It doesn't have more equity capital to continue to grow that company. And so it's at a natural point where they would exit the company. And in the years past, they'd sell the company. So instead, though, the KKRGP says, gosh, this is a great company.

5:20I'd rather not sell it. I'd rather own it for a few more years. But I need to give my limited partners liquidity for their investment. So they use the CV tool to be able to accomplish both of those things, holding on to a great investment they know well while giving liquidity to their limited partners. there's an interesting positive selection here the opposite of adverse selection in that they're choosing not to sell the asset and they want to hold it and they want to also roll up their carry into the vehicle which i know is a huge term for you guys in which cases would there be adverse selection in that the incentives are aligned for them to do a cv even though they might not love the deal does that ever happen and that's a large part of our diligence is making sure you know what we tell our investors is that, you know, we have the opportunity to invest in the best companies, you know, of the private equity firms with the positive signaling that you're mentioning that the private equity firm wants to hold on to it.

6:22You know, but, you know, you have to do your diligence because, you know, not all these companies, you know, are great companies, at least from our perspective. It may be a company that's subject to, you know, cycles, and it may have had customer concentration. It may have other issues. And frankly, what we're seeing a lot today because the markets are so backed up is we're seeing companies that have had a failed auction process that the GP says, oh, okay, well then I'll do a continuation vehicle on it. And by the way, I wanna do the continuation vehicle at the same valuation I couldn't get in the failed auction process.

7:02So, yeah, that's not a good deal for us. That's not alignment of interests. Large buyouts have so much dry powder. And if you're not able to sell that through a process, that is not a good sign in this market. Right, right. Yeah, these are high-quality companies we're investing in that, you know, should be able to sell in any market. And actually, you know, we'll talk about it later, but our DPI kind of shows that because, you know, our DPI is very strong because these are very high-quality companies that can sell, you know, even in this market. So maybe you could double click on the process from going from a fund to a continuation vehicle.

7:43Who are the buyers? Who are the sellers? Who's rolling their capital? Who's net new capital? So walk me through kind of a basic rudimentary explanation of the flow of funds. Sure. Well, the buyer is the continuation vehicle. So the first flow of capital, if you will, are institutions like Agility invest into that CV. We capitalize the CV. And then that CV is the buyer that, in my old example, buys the company out of KKR. So from the KKR's fund perspective, it just looks like they're selling a company, just like any other company they'd sell in their portfolio. It just so happens they're selling it to themselves.

8:31but with the new investor base. And then ultimately the capital that the CV uses to buy the company with the fund trickles down to the limited partners. Now there are some nuances to that. And you actually mentioned one is, you know, let's use some numbers. Let's say the KKR bought this company for a hundred million originally three years ago. They want to do the CV and now the company's worth$400 million. So the$400 million goes to the KKR fund from the CV. CV raises$400 million. CV actually raises, say,$480 million because they also want to raise growth capital. And then 400 of it goes down to the KKR fund to buy the company.

9:18The GP is owed carried interest, 20 % of that, 20 % of the gain. So they bought it for$100, sold it for$400. So there's$300 million a gain, 20 % of the gain,$60 million. The GP doesn't take money off the table. You mentioned this before. The GP rolls that$60 million into the CV, and it's their investment into the CV. The LPs get the$340 million, if my math's right,$340 million flows down to the LPs. but the LPs can choose instead of taking cash to roll their capital also into the CV. So if they decide they want to be a buyer, the smartest people around the table that are closest to the company have decided they don't want to sell.

10:07So maybe the LPs want to earn another two, three times on their money. They have the opportunity to roll into the CV also, or they can take cash. Most of them take cash. I had the CIO of an endowment tell me that by default, she was a default yes in CVs. In other words, most of the time she was leaning yes. Obviously, you have to do your diligence and all that, but she liked the asset class. But the IC was almost a default no in that they wanted the DPI given the lack of DPI in the asset class. So you have this interesting, I guess, psychological element of it that goes above and beyond what is the expected value and what is the kind of the stone cold math on the investment.

10:55Sometimes some LPs just want to have DPI. Right. And they want to deploy it into their next best investment also. They think they can get a two to three X on. So, you know, I can't blame them for that.

11:12Maybe you could tell me why would a GP want to do a continuation vehicle on their asset? What's the incentives? They're looking at it and buying a company that they know really well. They already own it, but buying it in another pocket. So they know this company really well. So it's a de-risked investment for them to make. And it's an investment where they've worked out the kinks, if you will. They've upgraded the management team, put the systems in place. And really importantly, they've developed the growth levers and executed on the growth levers. And they see continued white space to grow the company.

11:52So they know it really well. So why not invest in that company instead of or in addition to another company that they have 60 days to do diligence on, has all the heavy lifting ahead of it. So it's a de-risked investment for them. And then the economics are really compelling. So in the example I had before, they took their carry and rolled it into the new CV. So what did I say the carry was? $60 million, I think, in that example. So they have the opportunity for starters to take that$60 million and carry. And if they think on a de-risk basis, they can turn that into$120 to$180 million, double or triple it.

12:33That's a great investment just there of their own capital. And then in addition to that, the CV has capital. We raised in my fictional CV, I think$480 million of capital. 400 of it was to buy the company, 80 million was to invest in growth post-closing. Some of that's going to be dead as well, but they manage that capital like a fund, and they get carried interest on all that new capital. The one difference on the carry side I just will mention is that in your typical buyout fund, you know, they get a 20 % carry the GP, you know, after an eight to 10 % hurdle rate to the LPs. In the CV world, you know, we align interests a little better than that.

13:21We have a tiered carry. So your typical GP doesn't hit the 20 % carry until we agility and our investors get at least two times our money back and at least a 20 % IRR. So, you know, it's better, better aligned, But, you know, that's a huge amount of extra carry that they can get in addition to being able to triple their own invested capital. So said another way, the GP has done the work and which means provided a lot of value add created these systems to obviously they have to continue working and continue managing. But a lot of these systems have been set up. So they've done the value add and now they could essentially compound the returns from that value add.

14:04And two is there's a paradox investing is that the best diligence is to be an existing investor. So they've gone under the hood. They've been on the board. The portfolio CEOs are no longer in sales mode. They're actually in like operating management mode. They've seen the data points from how they communicate, from how they grow, how they execute. So they have more information on this current company than any possible, than could be done theoretically through any diligence process. because by nature, diligence has a sales aspect to it, but they're on the inside. So it's de-risked as well. Exactly.

14:42We talked about why it's attractive to GPs. Why are CVs so hot for LPs and why are so many LPs piling into the CVs? So for the LPs that are sellers, that are investors in the KKR fund, it just gives them optionality. So as we said early on, there has been a dearth of distribution since 2018, so for a long period of time. So this gives them an opportunity to get liquidity through the CV. But if they want to, they can take the optionality of rolling their investment and getting a 2 to 3x in a few more years. So it gives them optionality. Like we said earlier, most of them take cash from, and I think your question was also from LP, like our LP perspective, what's attractive about it.

15:39So from an LP's investing into an agility, the attraction is, you know, everything I mentioned before is we're getting an opportunity to invest in a de-risked investment. Our hold periods are shorter because they've already done the heavy lifting in the first few years of the investment. So typically we're looking at three to five years and we have a mechanism to actually force an exit if it doesn't happen. And also there's this uncommon alignment that we have with the GP. were not on the other side of the table where they're trying to, you know, paint the, well, I won't say it, but where they're trying to, you know, tell us.

16:27Let's use the word frame narratives. There you go. Where they're framing the narrative very positively relative to our questions and our diligence. You know, we're on the same side of the table, essentially, with the GP because they're buyers also, and we are tremendously aligned. So it's a really nice de-risked, shorter-term investment opportunity for our LPs. So tell me about the HEC Paris study on continuation vehicles or CVs. Sure. Well, HEC has done the most comprehensive study that I've seen. It's HEC, the Paris School of Management, and they've collected data on 300 CVs. So it's a pretty large sample size.

17:13And these are CVs that were created from 2018 to 2023. So the only problem is it's not a mature industry yet, so it's not a mature sample size. But they compared the CV returns against buyout returns. And what they found, the bottom line, is that CVs had a higher return than buyouts of similar vintage years. They had a higher DPI, so they delivered cash back to investors more quickly than buyouts. And they had a lower dispersion of returns, so they were less risky than the buyouts. And then applying some real numbers to that, if I look at 2018, which is the oldest vintage they collected data on, you'll see that single asset CVs, that's what we invest in in agility, had a total value of 2.4x.

18:05And 1.7x was actually returned in cash with about 700 basis points of remaining value. So 1.7 cash on cash return for the 2018 vintage with a 2.4 total value versus buyouts in the same year that had a 1.8x total value. So 1.8 compared to 2.4. and they'd only return 0.8x. So most of their value was still in the portfolio and not translated into cash. I should note that the stats I'm giving you are for the first quartile, so for the best funds. But you can see that it's really compelling. Is it apples to apples or is it first quartile CVs versus first quartile PE? It's apples to apples, first quartile to first quartile.

19:01And you could also make an argument, which I'm not sure if you're doing, which is not only do they perform better, but they're also de-risk based on the factors that we said, which is the GPs know the management teams and they're more compounding than doing kind of these highly disruptive changes within the company. Exactly. And I am making that argument. And HEC is backing up that argument with their data, which does show that there's a much narrower dispersion of returns in the CVs versus the buyouts, which implies it's less risky.

19:40So the CV asset class does not live in a bubble. It also is affected by specifically the returns of private equity, the lack of DPI in private equity. How does that lack of DPI play into the effects on the CV market? Does it affect the market in any way? Yeah, David, it's definitely expanding the market because it's viewed as another exit alternative in a market where it's difficult to exit companies. So, you know, last year, about 15 percent of exits were through CVs. And that's coming up from a decade ago was practically zero. It is viewed as an exit alternative. But the only thing I'll add is that that's not the only reason that CVs are growing.

20:27CVs are also growing because, as we mentioned before, the GPs recognize it just as a great way to play forward their best assets. Said another way, if you know the asset, you know the risk, you know the management team, why would you sell that asset and buy an unknown asset to replace it? It kind of doesn't make sense on a first-person basis. Yep, I need to take you on my roadshow. So taking a step back, CV started on larger buyouts. So tell me about how they started. And I know you focus on lower middle market. So let's start with why CV started up market and how that's evolved over time. Support for today's episode comes from Square.

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22:12That's S-Q-U-A-R-E.com slash go slash how I invest. With Square, you get all the tools to run your business with none of the contracts. or complexity. Run your business smarter with Square. Get started today. Yeah, nearly everything, at least in private equity, does start up market. And then, yeah, the trends continue down market. So right now, for the largest 100 private equity funds, 50 % of them have done at least one CV. Some of them have done multiple CVs out of different funds. And that is starting to bubble down market. On the why down market, why are we interested in the lower middle market?

23:02Buyouts in general, there's more return opportunity with the smaller companies versus the bigger companies. So, you know, it's easier to double a company that has 10 to 15 million dollars of EBITDA than a company that has 100 million dollars of EBITDA. And you also get the impact of multiple accretion by growing smaller companies to kind of the next level of buyers versus the larger deals where you don't have that opportunity. So there's a lot more alpha. There's a lot less competition, which is also part of that. You mentioned earlier that HEC's Paris study saw that CVs were less volatile. How is that measured and why do you believe CVs are less volatile than traditional bio?

23:56Well, HEC measures it by return dispersion. So they look at all the returns in their data set and how far they disperse from the mean. You're asking me to do statistics, which I'm not great at. And there's a tighter dispersion with the CVs than there is with the buyouts, which indicates lower risk. And I forgot the second part of the question. So essentially, you have the expected value, which is kind of the fitted line of returns, and then you have the noise around that. So if the standard deviation is much tighter on it, then that's how you measure risk. Exactly. Stayed in much better. You also invest in independent sponsored deals.

24:45So tell me about that market today. Yeah, yeah. So, you know, first of all, and I'm sure most of your listeners know, but, you know, an independent sponsor, for those that don't know, you know, these are buyout professionals, but they raise capital on a deal-by-deal basis instead of raising capital into a blind pool fund to invest later. So it's a very large market. So there, unfortunately, is not much data on the market, you know, but there's said to be about 1 ,500 independent sponsors in North America. You know, our database at Agility has about 1 ,000 of them, and it continues to grow all the time.

25:28And how much in deal volume is being done with independent sponsors? It's not hard data, but the common theory is that there's actually more deals done by independent sponsors every year than they are from the dedicated buyout funds. Now, these deals are a lot smaller, but there's a lot of them. And why are independent sponsors growing so quickly? Why is that market growing quickly? What are the confluence of factors? There's a bit of a supply demand going on here. So on the demand side, I'll start with is that investors are recognizing that there is a better return profile in lower middle market deals than there is in kind of the mega buyout deals.

26:17Some go to the mega buyout because they've got managers that there are reliable and safe and there's a lower beta. but there is an increasing demand for lower middle market deal flow. And so they're going to independent sponsors because, as I said, there's tremendous deal flow there. And the investor gets the option to choose which deals they go into. So the perception of the investor is that they're minimizing risk or reducing risk because they get to make the investment decision on each investment. On the supply side, there are more professionals that are joining the ranks of independent sponsors.

27:00And at least my theory is that since there has been a hard time raising funds over the past number of years, kind of corresponding with the lack of DPI to invest in funds, you've got kind of mid -level or mid-to-upper-level private equity folks that don't have a great path forward to partnership and wealth creation. So they're leaving private equity firms and they are becoming independent sponsors. And the typical path of an independent sponsor like that is they want to do a few deals as an independent sponsor, raising capital on a deal by deal basis, and then use that track record to raise a fund.

27:44I mean, it's similar to agility. I left my prior institutional firm, Fort Washington, and we've done eight deals basically as an independent sponsor. We did have one small fund that we raised during that period. But basically, as an independent sponsor, it's allowed us to do a few things. It's allowed us to build a track record. But importantly, it's also allowed us to build a team and become more institutional so that we can raise a fund, rather than me going out with a PowerPoint with Paul Cohn trying to raise a fund on my own. And also, it allows you to do deals versus marketing a hypothetical deal.

28:29So it allows you to actually get more reps as an independent organization. So just more useful as a GP. Exactly. You've been doing this for 15 years now. What are some of the most non-obvious lessons that you learned? You know, on the CV side, where I see CVs developing, especially single asset CVs and these mid-hold equity recaps, is that they're just going to develop into the buyout market. So right now we've got, you know, secondary players that are putting them into their very diversified portfolios. We've got, you know, the market grew out of the secondary industry. So we've got people that are used to, you know, evaluating portfolios, not necessarily deals, although, you know, they're all quite good.

29:19But, you know, what I think is when you look back 10 years from now, what you're going to see is, you know, the market's going to segment. And in the part of the industry that we focus on in the lower middle market, single asset CVs, they're just going to look like buyout firms. I mean, that was the thesis for agility is that I wanted to build a team of buyout professionals, bring a buyout culture to the market that not only did buyout style diligence, but also was focused on value creation post-investment. We have operating partners, you know, like a buyout fund. And our last deal that we closed, investment we closed, we brought in an operating partner that was the COO of FedEx.

30:09And so he was a logistics guy. This is a logistics company. He's serving on the board for us, just like a buyout fund would bring somebody like that. And then finally, you're going to see the portfolio composition look like a buyout fund. And so your typical buyout fund has a dozen plus or minus investments in it. They're fairly concentrated. Your typical secondary fund or the mindset of the secondary fund is to have large diversified portfolios to mitigate risk. We don't think you need to do that. We're mitigating risk with the alignment that we have with the GP, with where we're entering the market, partnering with these sponsors.