Investing in Private Equity in ’23 Could Prove Challenging to Over-Allocated Institutions

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.”

The challenge facing institutional investors is illustrated by the Oregon Investment Council, which held off increasing the Oregon Public Employees' Retirement Fund's allocation to private equity to 22.5% from 20%. The $89.7 billion OPERF currently has 28% of its assets in private equity. The Oreogn Investment Council, which governs OPERF, asked staff for other options beyond increasing the PE target.


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.”