By David G. Barry
Institutional investors should be eager to deploy capital
into private equity in 2023. The asset class, after all, capitalized on the
economic downturns at the start of the century and during the Great Financial
Crisis to produce stellar returns.
Speaking to the investment committee of the Pennsylvania Public School
Employees’ Retirement System (PSERS), Corina Sylvia English, a principal
with consultant Hamilton Lane, said, “the data shows the best time to
invest in the asset class is right now. You are buying into a business at a low
point – that is a value driver for operational focus.”
Scott Nuttall, co-CEO of KKR, concurred. Speaking on the investment
firm’s third quarter earnings call, he said that “in an environment like this, companies still need
capital. And we find private capital tends to have less competition at a time
like this. Public markets are more difficult. Corporate M&A is more
challenged. So, we've got a lot of capital to put to work. Companies still need
it.”
But numerous institutional investors – particularly public pension funds – may
need to overcome challenges to be highly active private equity investors in the
coming year. These includes being overallocated to the asset class, a reduction
in distributions and fund stakes selling at a discount in the secondary market.
Industry observers, though, say that it is a necessity for investors to continue
investing in the asset class and maintain exposure to the 2023 vintage year.
Vintage Year Diversification is Seen as Key
Josh Beers, a principal and head of private equity for NEPC, said
institutional investors need to continue deploying capital into the private
equity sector to ensure vintage year “diversification” within their portfolio.
“It’s super important,” he said. “You can go through business cycles where
there are some great opportunities and other cycles that are not great.” General
partners, he said, on average take three years to deploy capital – a period in
“which a lot can happen.”
Maurice Gordon, senior managing director and head of private
equity at Guardian Life Insurance for the past 12 years, said it’s
important to “keep investing and have good vintage year diversification.” Gordon,
who oversees a program with $4.5 billion in assets under management, said it’s
critical that institutions “don’t jump in and out.” Citing research done by
Cambridge Associates, Gordon said that even during downturns when returns
aren’t great, funds “ultimately come back and do all right. We just want to
make sure we’re continuing to invest.”
But to what degree some pension funds will be able to do so remains to be seen.
The biggest such issue, of course, is that many pension funds are
overallocated to the asset class, the result of strong returns and a surge in
fundraising by private equity and venture capital firms in 2021.
One thing that could aid their efforts is the continued markdown of assets by
PE and VC firms – especially with the asset class lagging one quarter behind
the public markets. However, those declines are likely to pale in comparison to
those being generated by public equities. As a result, while the values of
private equity portfolios have dropped, the asset class’s portion of overall
portfolios has not.
San Francisco Public Employees’ Retirement System (SFERS), for instance,
reported that as of September 30, its private equity portfolio – which includes
venture capital – is down 7%. Its public equities portfolio, however, has
declined 30%. As a result, SFERS’ private equity actual allocation is at 31.7%,
well above its 23% target. It is, in fact, the largest segment of the $33.5
billion plan as public equity is currently underweighted by 8% at 29%.
Distributions Are Down
It also doesn’t help that pension funds are seeing smaller distributions from
managers, the result of fewer portfolio sales and an almost non-existent IPO
market. Wes Bradle, a senior portfolio manager for private equity with
the Florida State Board of Administration (SBA), said that distributions
from its managers are tracking 30% lower in the second half of the year than in
the first half – a trend he expects to continue. “It’s normal for things to
slow,” he said. “It’s like the valuations of publicly traded software companies
today compared to where they were in 2019. They’re back to normalized
levels.”
SBA, however, is coming off a 2021 in which it received $5
billion in distributions from PE managers, which was a record year. The one
thing countering that, he said, is that contributions – or capital calls from
managers – are also down 30%a point with which other LPs concurred.
Shoaib Khan, chief investment officer of the $86
billion New Jersey Pension Fund, told the State Investment Council
(SIC) that “there is recognition that exits are slower today” and that he
and his staff are having discussions with the state’s general partners about
the outlook for distributions.
“The IPO market is obviously not as healthy – it’s far from being healthy,” he
said. “Deal flow has dried up significantly. What happens going forward will
determine how long this pause will be in terms of exits.”
For now, most institutional investors are in generally
strong positions financially and not reliant on returns from private equity
managers to meet monthly payments to pensioners. CIOs, though, are keeping a watchful
eye on the situation. One said that “fortunately, we have ample sources of
liquidity in other asset classes such as public equities to meet these
obligations, but such liquidity can dry up fast if not supplemented elsewhere
in the portfolio.”
Institutional investors have “an appetite for liquidity” in
the current environment, said Keith Brittain, a managing director with
Hamilton Lane. Many limited partners are dealing with a declining stock market
while their private markets’ portfolio hasn’t declined nearly as much. This is
creating an overallocation issue to private markets, which, he said, has
“heightened many LPs’ desire and need for liquidity.”
Concerns Expressed About Uptick in Continuation Funds
Much of the exit activity that has occurred of late, and
which may become even more significant in 2023 is via two means that limited
partners are not always eager to see: sales to other private equity firms and continuation
funds in which general partners form a new fund to prolong their ownership of a
company while providing liquidity to LPs.
Earlier this year, Mikkel Svenstrump, CIO of the Danish pension fund
ATP, said at a conference that he was concerned that private equity could
“potentially” become a Ponzi scheme – pointing to the fact that 80% of the
exits from the fund’s private equity portfolio were either to other PE firms or
through continuation fund deals. New Jersey State Investment Council members,
referencing Svenstrump’s comments, expressed concern about the industry selling
to itself. LPs often have concerns about PE-to-PE deals because they may be a
backer of both firms.
Michelle Davidson, co-head, advisory Americas for consultant Askia,
said at the New Jersey SIC meeting “that’s where you don’t want to be an index
and have exposure to too many managers.” She said it’s “not helpful” to have a
one portfolio company “traded amongst your own portfolio.” Investors, she said,
need to be “thoughtful and have a diversified portfolio.”
Continuation funds, meanwhile, raise concerns because of the general partner’s
involvement in valuing the company. A recent survey from placement agent Capstone
Partners found that LPs are not aligned with GPs on such transactions
because of concerns about pricing, conflict of interest, the lack of carry
rollover and motivation. As a result, many large institutional investors often
opt to take the liquidity as opposed to re-investing in the new fund.
A majority
of the secondary activity in 2021 was tied to GPs raising continuation funds.
Those transactions have been a bit slower this year, owing to the uncertainty
over valuations, but appear to be picking up steam. Zenyth Partners,
which invested in healthcare services, received backing from BlackRock,
Manulife Investment and Newbury Partners to continue its involvement
with three portfolio companies. Seven Point Equity Partners, meanwhile,
received support from its existing limited partners and new institutional
investors led by Timber Bay Partners to continue its ownership of The
RiteScreen Company, a manufacturer of window and patio door screens.
Mark Perry, a managing director with Wilshire Advisors, said there’s
“so much momentum” related to continuation funds that they’ve become “a
significant part of the secondary market.” The firm, however, has not invested
in any such funds, the result of “getting stuck” on how the incentives “line up
with limited partners and valuations.”
Fund Stake Prices Declining on Secondary Market
Investors who are overallocated to private equity could, in theory,
lessen the problem by selling fund positions in the secondary market. Prices
for private equity stakes are selling 15% to 20% below net asset value and some
venture capital stakes are selling 25% to 30% below NAV. Investors are seeing
potential value in their portfolio and holding off on such transactions – for
now.
“It’s tough for a lot of LPs,” said SBA’s Bradle. “If you didn’t sell in late
2021 or early 2022, you’re not going to like the price today. That may change –
but it’s unlikely to change in the near term.”
A chief investment officer of a multi-billion-dollar public pension plan that is
currently overallocated to private equity said selling into the secondary
market could “work with an adviser to meet pricing objectives and minimize
transaction risk. However, we are not running to the gates to begin trimming –
not just yet – but will take a methodical and deliberate approach.” He said his
preference would be to explore purchasing secondary interests “at a deep
discount and only sell into the secondary market as a last resort.”
Hamilton Lane’s Brittain, who focuses on secondaries, believes the
secondary market is poised to come alive.
“The secondary markets have been undercapitalized,” he said. “The capital
demand outstrips the capital supply. There’s not enough capital for all the
secondary deals that are coming.”
Whether he is right or not will have a significant impact on what happens to
the private equity industry in 2023. If overallocated pension funds opt to not
utilize the secondary markets, they’ll need to consider options if they wish to
maintain exposure to the vintage 2023 year.
Institutions Encouraged to Increase Allocation Target & Slow
Pacing
One method that seems to be gaining more traction is reducing the annual
investing pace. PSERS, for example, will look to invest $800 million to $1
billion in private equity annually – down from its prior pace of $900 million
to $1.2 billion. By doing so, the $75.9 billon system hopes to reduce its 17.5%
allocation to private equity to its 12% target in four years. The New York
State Teachers’ Retirement System (NYSTRS) also recently disclosed plans to
reduce the amount it was planning to invest in private equity in 2023 by $400
million.
Another method is to increase the asset allocation target.
Investment advisor Meketa is suggesting to overallocated
clients that they work within their governance models to accommodate their
higher allocation for a period of time, said Luke Riela, a firm
principal and coordinator of macro research and data analytics.
Secondary sales, said Riela, make sense if certain assets are not a fit for
client but are not worth pursuing for a “short-term reason.”
At this point in time, institutional investors should simply try
to “stay the course” with their private equity programs, he said. But he
cautions that it would be a “good idea to be prepared for a slower exit
environment in 2023, 2024 and 2025 given the decline in the equities market.”
Wilshire’s Perry said that private equity “is tough in a sense that crisis can
create opportunity. It’s the right time to want to be allocated in vintage
years of market dislocation. Pricing is down and there’s an opportunity to grab
market share from weaker or weaken competitors. There’s a fairly consistent
pattern of that but there’s a tumultuous market environment to fend through.”
Lots of Dry Powder
Of course, one thing which could disrupt the deployment of new capital is the
amount of dry powder, or unused capital, that PE firms have. According to
Preqin, private equity firms currently have $2.5 trillion of dry powder, up
from $1.9 trillion in December 2020. Blackstone, for instance, said in
its third-quarter earnings release that it has $182 billion of capital to
invest and KKR has $113 billion.
NEPC’s Beers, however, expects a “good piece” of the dry powder will be
“shoring up balance sheets in current portfolios.”
Perry said it should not matter to limited partners whether the
investment is coming out of a vintage 2022 or 2023 fund which can be more
technical designations. The key is dry powder and when and how it is deployed.
“Either one gets you there,” Perry said. “That dry powder could be
deployed very quickly.”
Assuming pension funds do have capital to invest, they’ll have to
give thought to the strategies or firms that might make sense in the current
environment.
Fundraising Is ‘Absolutely Slowing’
Meketa’s Riela said that larger firms “with the most established
brand names” appear to be having the most success in raising new funds. He,
however, expects first-time funds and emerging managers to face “a more
difficult, more challenging environment.”
SBA’s Bradle said fundraising is “absolutely slowing.”
Because of a Florida statue that does not allow the pension’s fund
alternatives segment – which includes private equity – to be above 20%, it has
been unable to commit to new PE and VC funds since earlier this year. It is now
trying to get the legislature to increase that limit, hopefully in early 2023.
Bradle, however, believes SBA will still be able to get into the funds it
wishes to get into. With less LP capital available, general partners are much
more willing to extend fundraising.
Almost every GP or placement agent he’s heard from in the past
three months who is planning to launch a fundraise has said, ‘besides being
overallocated – because everyone is – what are you looking at?’ Many of the
firms that set out to raise a fund last year were closing 2-3 months after
launching. Now, Bradle said many firms launching today are often looking at a
first close in April or June of 2023 and expect to spend the rest of the year
on the fundraising circuit.
“The fact that pacing is slow makes sense,” he said. “For buyout funds, there’s less leverage available and it’s more expensive. For VC funds, companies are slowing their burn rate and extending timing between fundraises in order to grow into their last round valuation.”
What firms are facing in the market is shown by Apollo Global Management, which has decided to keep its flagship private equity fund open through the first half of 2023. The firm has raised $14.5 billion of its $25 billion target. During Apollo's third-quarter earnings call, Scott Kleinman, president of Apollo Asset Management, said the move is being made "to accomodate our investors' annual allocation budgets."
NEPC’s Beers, expects fundraising to get longer and that some
firms – most likely on the venture capital side – may go out of the business
because of an inability to raise new capital.
“It will be a flight to quality,” he said.
Wilshire’s Perry said the firm focuses on picking managers “who
have the tools to capitalize on complexity and a strategy that takes advantage
of dislocation.”
Wilshire, he adds, favors younger firms. That, however, does not mean the firm
say no to “every fund seven or yes to every fund two.”
It also leans toward smaller firms.
Askia’s Davidson told the New Jersey SIC that from what the firm
has seen in prior downturns, “it is an attractive environment for private
equity with companies at lower valuations.” But she said it’s important to back
the right managers.
“I’d say generally the industry does well in this environment, but it
does come down to manager selection,” she said. “You have to be careful about
that and back the right managers who've shown they can pursue this model
successfully over time.”
