This article is sponsored by BlackRock
Per PEI’s LP Perspectives 2023 Study, 21 percent of LPs intend to invest less capital in PE over the next 12 months, compared with 7 percent last year. What are some of the market drivers behind that?
More LPs are dealing with the denominator effect, as the net asset values in their private equity investments have declined at a slower rate than the rest of their portfolio. However, I think there is a different type of behaviour now than we saw in the global financial crisis. Many investors who are cycle-tested are trying to reflect on lessons learned.
Back in 2008 and 2009, several investors halted their private equity allocations. When they finally started to begin investing again, it took them years to catch up to their target allocation, given the dynamics on the difference between commitments versus the time it takes to call down. Trying to get back on to the ramp again on the other side can be challenging.
We also now have data available showing that, overall, average private equity returns tend to do well through economic downturns. In fact, in some areas, the outperformance premium of private versus public can widen during periods of economic turmoil.
Yes, investors are slowing down their private equity allocations in general. But are they stopping? No, at least not at this stage.
What should LPs be expecting from their GPs in the current environment?
On the buyout side, the prepared and cycle-tested GPs should be working on re-underwriting their entire portfolio, assessing where the portfolio is going to turn out assuming slower top-line growth, rising rates and cost of debt, looking at variable versus fixed rates in the debt structure, assuming a lower exit multiple on the other side and the impact of inflation on the cost structure.
On the venture capital side, VC firms are trying to assist their companies to survive an extended downturn and avoid raising new rounds of capital at lower valuations. If you are performing today, as a growth company, you may not want to go out and raise capital. So, we are seeing layoffs and companies employing different strategies on raising new rounds to maintain flat valuations.
How are investors assessing their current portfolios and thinking about new allocations for 2023?
The first thing many investors are doing is trying to forecast over the next three to five years what they think their cashflow activity will be: capital calls, distributions and NAV development. If they can get comfort on these ranges, then they can be more precise in how they think about pacing. This allows them to maybe not stop the flow, but at least slow it down. The second piece is thinking, ‘if these could be some interesting vintages, how do I ensure I’m active?’ They might look at proactive secondaries sales, perhaps cleaning up tail-end funds.
Portfolios that historically might have been 100 percent primaries are now rotating more to direct co-investments and secondaries. What you might see is investors that are not only thinking about selling into the secondaries market with legacy primary fund commitments but considering what they want to do when they harvest that cash.
Secondaries sales reduce NAV, they help to solve any denominator effect, but then the investor can rotate into being more opportunistic and dynamic in the direct co-investments and secondaries spaces. That may allow them to reduce their total cost of ownership in private equity, take advantage of market disruption and get capital to work faster as we move through the cycle.
What does a successful approach to direct co-investment look like, in your opinion?
It’s about having a proactive approach where investors are thinking about the scale and diversity of their dealflow, and whether they are being brought in early enough as a partner to help co-underwrite or anchor a transaction. If they can do that, they have more time on diligence and the opportunity to influence price, terms, structure and maybe governance.
In terms of independent due diligence, it’s about whether investors can re-underwrite the transaction, reference around it and also ensure they can get adequate allocation into the investment.
It’s also about having the expertise, knowledge base, resources and network to think about the sourcing, the underwriting and, in these times, the monitoring. There is a lot of work that goes in post-transaction to track a company’s performance, the top line, cashflow, covenant compliance, liquidity and refinancing risk. Investors need to stay on top of all these things because as we go through any economic downturn, there are going to be more situations where companies need help. Investors need to be on the front foot preparing for potential follow-ons or, in downside scenarios, potential restructurings or rescue financing.
What is investor appetite like for secondaries, both in terms of LP-led transactions and committing to secondaries funds?
“Many investors who are cycle-tested are trying to reflect on lessons learned”
Secondaries investing is at the top of the list when we are speaking with investors that want to remain active in the private equity markets. It is normal now for investors that might be selling assets on the secondaries market with one hand to also be thinking opportunistically about how to invest in secondaries. There is this greater comfort factor of doing a health check on the portfolio and thinking about ‘where should I trim?’, but at the same time, ‘how do I want to take advantage of dislocation in the market or what could be an interesting buying opportunity?’
Based on current discussions, we expect to see volume continue to increase both in LP-led and GP-led transactions.
Given the increase in LPs looking to sell, are fund stakes still commanding a reasonable price?
Private equity is creative, solutions-oriented capital. In a secondaries transaction, it’s not just about price, it’s also about the structure and the overall terms. For investors looking to sell, there are a lot of different approaches they can use to optimise the terms. Sellers can certainly find someone that will engage in the right way. The market continues to grow in terms of participants and the depth and range of the transactions.
As we know, the primaries of yesterday are the secondaries of tomorrow, so we can look at the growth of the primary market and the overall commitments over the last decade to get a sense of just how massive the opportunity is going to be on the secondaries side in the years to come.
How are you seeing the PE investor base shift?
There are a couple of developments that are worth watching. One is an overall macro shift in the equities markets, as the population of listed companies shrinks and the universe of private companies grows.
A second dynamic is that earlier- and growth-stage companies are staying private for longer. Because of the expanding ecosystem of growth equity investors, founders of businesses are not as reliant as they used to be on the public markets earlier in their life, either to look for liquidity or expansion capital. This means, as an equities investor, you need to think about, by the time these companies may go public, what has already been the equity value creation during that time, and what have I missed out on? Is there an opportunity cost of not thinking about my allocation on the unlisted equities market versus the listed market?
These dynamics, along with the historically attractive returns in private equity, have led more investors to increase their allocation to the asset class. What will be interesting is, in the next decade, do more investors start to think of private equity as equities? Does it go from alternative to core and start to be viewed as equities? Now we have the data to analyse private equity in the right way linked to our public equities exposure, and we’re getting more transparency, and we’re getting the opportunity to expand our private equity portfolios on an implementation standpoint.
This leads to the universe of private equity investment participants expanding. What used to be a linear equation, that went from company management to general partner of the fund to limited partner in that fund, and potential co-investor, has now been disrupted into more of a sphere, where the companies are at the centre, and they’re thinking about who they want in their shareholder register. That population of potential investors still includes all the successful GPs out there, in addition to emerging managers and fundless sponsors, but now also we have the rise of sovereign wealth funds, family offices and asset managers. Companies are being more thoughtful around that overall population of investors to create a durable investor base.
What role will individual investors play?
We would expect over time that individual investors’ allocation to private equity will continue to increase, particularly as forward-looking public market return expectations come down against a more challenged macro backdrop. For individuals, thinking about and planning for liquidity needs has been one of the biggest factors.
Fortunately, there are more tools available now, and we see more investors who are moving beyond fund picking and thinking about outcomes they want to create in their broader portfolios: ‘What is my target allocation to private equity and is that enough to amplify overall portfolio returns? How long does it take me and how many managers are needed to achieve diversification? What are the exposures that I want?’ Unfortunately, these questions may be moot without appropriate investor accreditations or access points.
On that note, we are seeing the rise of new structures and offerings, such as evergreen, fully funded, limited liquidity vehicles built specifically for individual investors. Not only should these kinds of innovations allow more investors to participate in private markets, but they can also alleviate some of the potential friction points of traditional private markets investing.
Johnathan Seeg is global head of business and product strategy for BlackRock Alternatives’ private equity business