Newsmakers
HighVista’s Raphi Schorr: Continuation Funds Are More Than Liquidity Solutions
The deputy CIO argues that extended private ownership is a structural shift, not a temporary market dislocation, and says the vehicles are becoming a permanent feature of private equity.
Reported by Matt Toledo
Raphi Schorr
The prolonged slowdown in private equity exits has pushed continuation vehicles and other secondary-market solutions into the spotlight. CIO discussed these trends with Raphi Schorr, deputy CIO of Boston-based alternative asset manager HighVista Strategies.
As private companies remain private for longer and sponsors increasingly seek alternatives to traditional exits, Schorr sees continuation vehicles becoming an integral part of the private equity tool kit, rather than a niche solution for use in difficult markets.
CIO: Why is ‘private for longer’ structural, rather than cyclical?
Schorr: The starting point is that we lived through a very unusual period. The post-[global financial crisis] world, really 2009 through 2021, was a great bull market, with rising prices fueled by low interest rates. Real 10-year yields hovered around zero [for] over a decade, leading up to the rate reset in 2022. In that kind of world, everyone feels good with rising asset values, cheap borrowing and growing profits. That feel-good world is one that draws even more investors into newer asset classes.
That was true broadly, but especially in private equity and venture capital, where investors wanted to allocate more and more capital, and the flows helped contribute to higher valuations. Sponsors bought companies from each other at higher and higher and higher prices, and hold times got compressed as sponsors with large pools of committed capital hunted for assets in the portfolios of their competitors. An investor might have bought a company for 10 times EBITDA, added some leverage, and then sold it a couple of years later at 12 times to another sponsor for roughly [twice the] money. That second sponsor could then hold it for a few years and sell it on to a third sponsor at 14 times, again roughly doubling their equity investment. That was the world we lived through.
We are now in a different world. I don’t think private assets are going to keep growing quickly relative to the overall pool of wealth; there just isn’t as much of an adoption curve left ahead of us. So that sponsor-to-sponsor flip to an ever-higher multiple is potentially gone, and the basic math reasserts itself. To make two times now, you need free cash flow and earnings growth. Compounding at a low-teens rate gets you roughly a six-year hold, not the three or four [years] that might have worked in the past. Take away the quick flips, and holds are simply longer. That part is structural, and it doesn’t reverse when the cycle turns.
There’s a cyclical piece on top of it. When rates reset in 2022, a lot of what got bought in the run-up—2019 through 2021—was done at valuations that don’t really make sense in today’s interest-rate environment of nearly 5% nominal and 3% real. So [the asset class has] an acute backlog [of companies to sell], and even after this backlog clears, the structural change will hold.
Analysis has [largely] focused on private equity. The dynamic in venture capital is a little different. We are living through an incredible cycle with a huge number of startups and very large pools of funding for these companies that come in many different forms. This is an environment where I think venture-backed companies will stay private for longer, as the market is increasingly structured to allow more companies to raise more rounds of capital over longer periods of time. This is an important structural shift.
CIO: How has the market for lower or midsize companies behaved differently from the market for larger private companies during the slowdown in exits?
Schorr: The lower middle market is connected to the broader private equity market, so when valuations move or the market slows, it trickles down. But there’s a basic difference: A very large, PE-owned business eventually has to find one of three exits: a way back to the public markets, a strategic buyer (which gets less obvious the bigger the company is), or a new kind of private equity that’s lower-fee and can hold for longer. [We’re] at the top of the market, [and] that’s a real problem.
I don’t think that problem exists further down. Lower-middle-market companies still have plenty of natural buyers. They can sell up the food chain to bigger sponsors such as middle-market firms looking for good businesses. They are also much easier to digest for strategic buyers, so the exit paths in the lower middle market never really closed the way they did for the mega-cap names.
CIO: Many investors still view continuation vehicles primarily as liquidity solutions. Why do you see them as compelling standalone investments?
Schorr: Continuation vehicles have exploded in the last few years. [General partner]-led secondaries—and CVs are the biggest part of that—have grown to roughly half of the whole secondary market, and in the first half of this year, many of the major brokers had GP-led volume just edging past the traditional LP-interest market for the first time since 2021. When people think secondary investing, they still picture buying portfolios of [limited partner] interests, but the GP-led side has grown to rival it.
What a CV gives you is liquidity for the LPs who want [distributions], whether that’s part of their program or just their own preference for a more liquid book. Either way, the LP gets to choose liquidity, while the GP gets to keep holding a business it believes in.
So why is that a good investment and not just a liquidity mechanism? Because the people with the best information about a company’s prospects are usually the management team and the GP. They can see around the bend. That’s unusual. In most of the investment world, outcomes feel either random or already priced in. Here, it’s neither fully random nor fully priced, partly because private equity values businesses on a backward-looking basis, historical earnings and growth, because that’s the defensible thing to do. Sometimes a business that’s grown well has dim prospects ahead, and sometimes it has bright ones. The people closest to it know the difference, and a CV lets them keep backing the winners.
And because GPs want to hold onto their best businesses, the incentives line up. The GP rolls their own capital and their carried interest into the vehicle, so they’re sitting alongside the new investors, rather than across from them.
CIO: What separates a high-quality continuation vehicle from one that simply delays an exit?
Schorr: This one is really about the worry the market has, which is that a GP uses a continuation vehicle to keep a struggling asset alive, and [to keep] the fees that come with keeping the investment going, rather than because the business genuinely deserves more time. That’s a fair concern, and it’s exactly what separates a good CV from a bad one. It comes down to three things: alignment of interest, price and a real plan.
On alignment, the GP should be rolling real capital and crystallized carry into the new vehicle—investing alongside the incoming buyers, rather than just cashing out. On price, the valuation should come out of a genuine competitive process with real third-party validation, not a number the GP chooses for itself. [Finally,] there should be an actual plan to build value from the CV price, including operational work and growth. This is not just an exercise in financial engineering.
When those things are there, a CV is a way to keep owning a winner. The potential opportunity is to buy a business that can grow at above-average rates while paying an average price, and that extra growth can compound nicely over time. Without the alignment, reasonable price and a real plan, a CV is just a way of buying more time and [is] far less exciting for the incoming investor.
CIO: Does the ability to roll into a continuation fund or take liquidity genuinely improve outcomes for LPs?
Schorr: Undoubtedly choice is the key here. Investors have historically been subject to a one-size-fits-all approach to portfolio management. An investor signs up for a fund and is then tied at the hip with a bunch of strangers and a [GP], each with different timelines and preferences. That is the nature of pooling capital to allow the investor to access investments that they couldn’t possibly access on their own.
That model has obviously evolved with the ability of limited partners to sell their position in the secondary market. But the continuation technology brings a more profound choice to the market. The [GP] can now hold onto an asset but give investors greater flexibility and choice, which is itself an important outcome. In terms of returns, CVs create efficiency by allowing experienced sponsors to hold on to businesses for which they can foresee and effect potentially great outcomes, rather than sell to create [distributions] and force all LPs to cede their ownership.
CIO: What does the private equity ecosystem look like five years from now if private ownership continues to lengthen?
Schorr: Looking out, large private equity first has to earn the valuations at which their portfolio companies are currently held. They will have to grow into the valuations, and then the sponsors will be able to exit to strategics, the public markets and new forms of private capital. Thus, [distributions] could normalize, investors will adjust their expected hold periods, and the market will be far more balanced.
We are probably living through what will turn out to be among the longest liquidity dry spell as the companies bought in the years leading up to 2022 will take a lot of time to achieve liquidity. Post-2022 vintages should be far more normal … particularly given the fast adoption of a range of secondary technologies, with CVs being among the most significant of those technologies as we sit here today.
The CV will stop being treated as special and will become one of the handful of exit paths that a GP considers before they have even purchased the business. GP-led secondaries, combined with a more and more liquid LP secondary market, transform the ‘private for longer’ phenomenon from a problem to a well-understood feature of how the asset class works.