Traditionally used by PE, the vehicles are increasingly popular with VCs in a more constrained exit market.
By Leah Hodgson

Continuation funds have already become mainstream for PE, but now they are being adopted by VCs who are also looking to solve LP liquidity issues.

Large-scale VC investors, including General Catalyst and Insight Partners, were early adopters, using them to extend ownership in breakout assets and manage aging portfolios more effectively. Now, smaller and mid-sized VCs are following suit.

Last week, US secondary investor Ion Pacific partnered with Vienna-based VC firm Speedinvest for its second continuation fund this year. Michael Joseph, co-founder and co-CEO of Ion Pacific, spoke to PitchBook News about how VCs use these vehicles to solve liquidity issues.

This interview has been edited for length and clarity.

PitchBook: Why are VCs looking at continuation funds?

Joseph: Secondaries for VC are relatively new for venture and growth, but continuation funds are especially so. Most of the secondary activity, whether GP or LP-led, has been concentrated around PE, and VC is just now starting to recognize the opportunities for liquidity.

When you think about it, what’s surprising is not that VCs are looking [at continuation funds], but that it’s taken them so long to get there. VC invests in innovation, but, as an asset class, it’s one of the least innovative ones I’ve seen.

VCs have relied on M&A and IPOs for their exits, and they’re realizing that those aren’t enough opportunities for liquidity. There’s been more capital flowing into the asset class, but there hasn’t been that same increase in M&A or IPOs.

The next round of fundraising for a GP is going to be increasingly predicated on their ability to realize exits. There’s more competition between GPs, and there are more of them than 10 or 15 years ago. LPs may have previously looked more at strategy to select managers, but what they’re looking at now is who is able to realize value consistently.

Why aren’t there more of them?

The number one reason is internal resources. VCs are sophisticated finance people, but they’re focused on other things, like working with founders and developing portfolio companies. Many don’t have the investment banking background that would have given them the skill set.

The other part of the equation is that there hasn’t been dedicated capital. The secondary market for PE has become massive, and though there are big players looking at VC, it’s nowhere near the same. If you’re a big secondaries platform, why should you care about VC? Are they really going to be writing a $10 million to $50 million check in a VC continuation fund, when they’re managing $20 billion or even $2 billion?

If they decide that it’s not too small, which it is for most people, then the work they have to put in to get comfortable with the underlying assets is greater. Let’s not forget that VC assets, even at the later stage, are not necessarily generating free cash flow, which is usually what PE secondary players underwrite. So if I don’t have that basic metric, I need to dive deeper and be more of a specialist in the underlying companies.

“If you don’t have dedicated people focused on liquidity, then continuation funds are a nice thought, but the execution is difficult.”

Michael Joseph, Ion Pacific

The third thing is that VC continuation funds are more diverse than in PE, which typically hold just one asset. If you take it all together, are you, a big secondary player, going to write a $25 million check to underwrite 5 to 10 assets that aren’t generating free cash flow? A lot of people would throw their hands up and move on to the next thing.

Because of that, there’s a lot of scope for investors like us to seize opportunities in a largely unattended market.

Are continuation funds reserved for larger VC firms?

It depends on the fund manager’s DNA. You can have a solo GP running a $75 million fund who is financially astute and willing to do the work to get it done. I don’t think size is the gating factor, but willingness and motivation.

Managers have been choosing not to engage because liquidity was around the corner. Setting up a continuation fund, hiring lawyers, figuring out how to optimize for tax and structure, etc., was just too much hassle.

A lot of those people are now in a tough spot because the queue of companies looking to get liquid is massive. The luxury to wait has gone, and GPs are cognizant, or at least should be, that they are competing with the outfit across the street that just provided liquidity to their LPs, who will be in a much better position when the next fundraising cycle comes around.

That said, if you don’t have dedicated people focused on liquidity, then continuation funds are a nice thought, but the execution is difficult.

How can a perceived conflict of interest in such deals be addressed?

There are a few different things you can do. You can always roll over to your LPs. If they don’t like the price at which it’s being sold, they don’t have to sell. You can get an outside fairness opinion or let the market set the price. Any of those three things takes the conflict of interest largely out of the question.

What trends are you seeing around pricing and valuation?

There’s no straightforward answer to the pricing we’re seeing in the market. It depends on a number of things, but generally speaking, Europe is going to trade at a bigger discount to the US and Asia than to Europe.

You’ll typically get a higher discount for earlier-stage assets further from liquidity. If you’re a pre-IPO company but your financials and cap stack are a mess, you’ll get the same thing, even though the time to liquidity is shorter.

It’s nuanced, but generally, LP stakes would be trading at more of a discount than a continuation fund because you’re taking both good and bad assets.

The exit market has begun to open up again. Will VCs still pursue continuation funds when traditional avenues for liquidity are more viable?

The asset class has grown so much larger than the exit market that there’s no going back. Continuation vehicles and secondaries are and will remain a large portion of exits generated by managers, and it’s only going to grow.

VC is the most illiquid asset class, so if any sector needs means for alternative liquidity, it’s this one.