The exit winter for private equity persists.  Even as the number of private equity sales increased year over year, the volume of buyout fund exits reached a five-year low in 2024. Data by S&P Global Market Intelligence suggest that the total deal volume declined to $515 billion last year, down 35% from the peak in 2021.

An extended slowdown in exits has material consequences for funds.  Low deal volumes limit available liquidity for distribution from older vehicles for general partners (GPs) and limited partners (LPs). Additionally, they slow the establishment of new fund vintages and can leave mature funds with small, concentrated portfolios.

Continuation funds can unlock liquidity.  We expect private equity will continue to ramp up its use of continuation funds to increase the number of exits. In combination with existing and novel debt financing strategies--for example, GP financing and dual-pledge financing--these vehicles can be used to unlock liquidity for GPs and LPs, which rejuvenates fund lifecycles for managers.

We believe GP financing and dual-pledge financing, both of which are rising in popularity, will increase secured debt on funds' balance sheets. We note that these strategies have unique credit characteristics that influence our evaluation of their creditworthiness.

Leverage In Private Markets Continues To Increase

Short-term flexibility comes at the cost of increased financial risk.  Continuation fund financing can help GPs thaw frozen liquidity, but it introduces leverage to often unencumbered asset pools. This is accompanied by a broader increase in secured funding to mature private equity funds.

Even though debt can help unlock liquidity after a challenging three years for private equity, it creates long-term leverage on the sector balance sheet.  Estimates suggest that secured funding to private equity, which is underpinned by a fund's net asset value (NAV), represented about $100 billion in 2024. While this amount is increasing rapidly, it is still low, compared with the private equity sector's unrealized NAV of more than $7 trillion.

Continuation Funds Helped Weather The Exit Freeze In 2024

Despite signs of a tentative recovery, 2024 was a challenge for private equity.  Private equity markets recovered slightly in 2024. Distributions to LPs exceeded capital calls for the year, while performance was strong enough to recover the value that was lost in the valuation drawdown in 2022.

Nonetheless, fundraising across the sector declined year over year, as did the number of new deals. Exit volumes were subdued (see chart 1) and older vintages continued to see slow returns to LPs (see chart 2).

Chart 1

Chart 2

Continuation vehicles were a release for the industry.  Continuation vehicles are designed to aid funds in the later years of their lifecycle (see chart 3). These funds, also known as GP-led secondaries, purchase assets from a GP's mature funds. This returns liquidity to the maturing vehicles that can be returned freely to LPs.

LPs can then follow the manager into the continuation fund or cash out and retain the returns. After a strong first half in 2024, estimates suggest that continuation fund deals comfortably exceeded $50 billion last year, with some estimates approaching $80 billion.

Chart 3

Debt Can Help Establish A Continuation Vehicle

The success of continuation vehicles hinges on GPs' ability to invest into the new fund.  However, a significant portion of GPs' cash is tied up in stakes in prior fund vintages and can only be unlocked by asset sales. These stakes are placed in management companies, which also aggregate the management fees payable to GPs in their role as fund managers.

This is where GP financing comes in (see chart 4). It enables GPs to invest fresh equity into a continuation fund by unlocking the necessary liquidity of typically more than 5% of the new fund's total commitments.

The funding is secured by the aggregated value of existing ownership stakes held in the management company--including past gains on fund vintages--and the stream of contractual cash flows from managing underlying funds. GP financing is highly bespoke and often used for unique purposes, including succession planning for fund partners.

Chart 4

Once established, continuation funds use leverage across their lifecycle.  Traditionally, fund finance facilities are secured separately on the key assets of a fund through its lifecycle, uncalled capital commitments (subscription financing), and NAV (NAV financing). Yet certain structural features of continuation strategies impair traditional funding.

First, the concentrated asset base of continuation funds can be restrictive. These funds often include less than 10 individual assets, which is significantly below the typical borrowing base of a conventional NAV facility. In a typical continuation fund, for example, the number of assets is close to the level that triggers a NAV facility's concentration covenant, to amortize the facility at an accelerated rate.

On top of this, the LP base of a new vehicle can be similarly concentrated and only include a handful of essential investors. This reduces the value of collateral that is available under many subscription line lenders' underwriting methodologies.

Together, these features can make traditional funding prohibitively scarce and expensive. In response to this, fund finance providers have introduced new structures, such as dual-pledge facilities (see chart 5). Also referred to as hybrid facilities, they enable a concentrated fund to borrow against its uncalled capital and NAV across its entire lifecycle.

Chart 5

Our Approach To Continuation Funds

We rate continuation funds and their debt.  Continuation funds holding private equity assets fit into our alternative investment fund (AIF) methodology (see chart 6). Respective fund managers tend to have the required track record to be rated because they source their assets and LP base from existing funds.

Further, continuation funds' legal incorporation, maturity transformation, and funding mix fit well into our AIF framework. Under this framework, we rate debt based on our view of the fund's creditworthiness, which is reflected in the issuer credit rating.

Chart 6

As per our AIF framework, a continuation fund's characteristics can affect stressed leverage, risk position, funding, liquidity, and, ultimately, the issuer credit rating.

Stressed leverage:  The dual-pledge facilities used by continuation vehicles tend to limit the amount of leverage that can be extended to a continuation vehicle. For example, some facilities will stipulate that the debt amount must not exceed the value of uncalled capital commitments outstanding.

This means that the absolute debt amount will be very low, compared with a fund's asset base, once the continuation fund has reached a mature stage. This low debt level tends to be commensurate with a positive assessment of a continuation fund's leverage.

All else being equal, the debt amounts that lenders are willing to extend to continuation funds are generally contained. This reflects the significant concentration penalties in lenders' underwriting.

In our view, this limits a continuation fund's level of indebtedness versus typical private equity funds. We consider that this supports robust stressed leverage outcomes and that these supportive traits are also common for a GP financing vehicle.

Risk position:  The high asset concentration in continuation funds and GP financing vehicles will carry a material ratings penalty in our assessment of the risk position. In our risk position assessment, we capture the financial risks--including concentration risk--that a fund is exposed to and that are not reflected in our leverage assessment.

We do not adjust our market risk haircuts, which we apply to a fund's private equity portfolio, for concentration risk. As such, we penalize concentrated portfolios in our risk position assessment. This can lead to downward adjustments of our stressed leverage assessment.

Even so, the significant leverage headroom in most continuation funds means that our assessments of a fund's stressed leverage and risk position ultimately support the rating.

Funding:  Our funding assessments of closed-end continuation funds with diversified equity and debt funding tend to be neutral. Some continuation funds have highly concentrated LP bases, with sometimes only one cornerstone investor in the vehicle providing equity capital. We do not consider it a weakness if the single investor's capacity to withdraw funding is limited.

Even so, absent significant protections, the atypically high investor concentration of some continuation vehicles is a significant rating constraint.

Liquidity:  A typical NAV facility to a buyout fund receives minimal predictable cash flows from a fund's equity stakes, with most investments producing no recurring cash flows. This also applies to typical continuation fund financing, including dual-pledge financing.

By contrast, management fee cash flows that can be secured under GP financing facilities provide liquidity uplift above typical private equity fund structures. Even though underlying assets remain illiquid, this cash flow stream differentiates continuation funds from most private equity-exposed structures.

Rating:  The balance of these strengths and weaknesses can support an investment-grade rating on continuation vehicles, in line with our existing ratings on mature private equity funds.

Our issue ratings on dual-pledge facilities benefit from material support.  To rate a fund's issuance, we reference the issuer credit rating. For a typical senior secured or unsecured loan, we rate the issuance in line with the issuer credit rating.

That said, we believe the extension of security across uncalled capital and NAV to a dual-pledge facility lender provides material uplift to the facility's creditworthiness. An uplift of up to two notches is possible if the amount of uncalled capital is significant and overcollateralization is available to repay the facility at the end of its life.

Table 3

Related Criteria And Research

• Bottleneck In Exits Will Increase Some Alternative Investment Funds' Leverage, Sept. 3, 2024
• Alternative Investment Funds Methodology, Aug. 30, 2024
• An Overview Of Our Proposed Criteria For Rating Subscription Lines Secured By Alternative Investment Funds' Capital Commitments, May 20, 2024
• Rising Global Defaults Will Test Private Credit Funds In 2024, May 1, 2024
• How We Rate Alternative Investment Funds, Feb. 23, 2024
• ABS Frontiers: The Blurring Of Private Credit Funds And CLOs, Jan. 30, 2024
• Uneven Liquidity And Strained Valuations Are Pushing Some Funds Toward Debt, Sept. 28, 2023
• Credit FAQ: Defining And Rating An Alternative Investment Fund, March 31, 2023
• Difficult Markets Will Test Europe's Rated Alternative Investment Funds, Dec. 5, 2022