David Lebovitz:   Welcome to the Center for Investment Excellence, a production of J.P. Morgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is on opportunities in private equity and has been recorded for institutional and professional investors.

I'm David Lebovitz, Global Market Strategist, and host of the Center for Investment Excellence. With me today are Ashmi Mehrotra, and Stephen Catherwood, co-heads of the Global Private Equity Group. Welcome to the Center for Investment Excellence.

Ashmi Mehrotra:   Great. Happy to be here.

Stephen Catherwood:   Thank you for having us.

David Lebovitz:   My pleasure. Well, certainly a lot to talk about today and private equity is something that's been coming up more and more in client conversations over the past couple of months. And I think a lot of the questions really tie back to the broader uncertainty about the macro view and what this means for private markets broadly and private equity assets in particular.

And so, when we look at the world today, we've been surprised by how resilient global growth has been during the first few months of this year. We recognize that that better global activity data has also contributed to core inflation that is a bit stickier than perhaps a lot of people were expecting.

And while we think we understand the path ahead for the Federal Reserve, when we look at the way futures markets are priced, we do pause. It seems almost unreasonable to us that the Fed eases as aggressively as what markets are pricing in during the back half of this year. And the implication of that for risk assets broadly, particularly public assets in the current environment, is that valuations are too high and will need to come back down to earth.

Now, people have been having a similar conversation about the private world for some time. We began to see private equity assets reprice into the end of last year and the beginning of this year. But I want to start the conversation with kind of a 20,000-foot view of the private equity world at large.

Steve, maybe we'll start with you. Can you just talk a little bit about what happened in 2022 from a performance perspective? Where were you seeing valuations begin to get adjusted kind of into the end of last year and the beginning of this year? And then at a very high level, and we'll unpack this in more detail, what's your outlook for 2023?

Stephen Catherwood:   Sure. So, we cover two main areas within our group, which is venture capital and buyouts, and both have very different characteristics. So, looking back to 2022 and just starting with venture, it was a pretty massive amount of change within the venture capital markets and portfolios in 2022.

And it really started in the fourth quarter in '21, led by valuation compression of high-growth technology stocks that had seen during the COVID period, massive run-ups in valuation and tremendous expansion of the valuation multiples of revenue that were assigned to those businesses. And that flowed through to the private markets.

So, valuations were very high as the public market started to correct in the fourth quarter. That was flowing through to private markets, which made it a lot more challenging for deals to get done. A lot of businesses raised a fair bit of capital when capital was plentiful and cheap in late 2020 and 2021.

So, they did not necessarily need to come back and raise new capital. And investors were adjusting their pricing to reflect the fact that those valuation multiples had come down. And so, the companies didn't need to raise new money. Investors didn't want to complete new deals, unless they were seeing very different valuation environments.

So, that led to a contraction in overall activity. And if you looked at the valuations of the underlying VCs, what they were doing with their marks for their portfolios, they did take them down in most cases meaningfully during the year, both discretionary write-downs on private assets, as well as flowing through the mark-to-market on any mark-to-market valuations on any publicly held securities.

So, the combination of those two led to healthy double-digit write-downs in a lot of portfolios there and some of that overall transactions and pricing softness has certainly carried into this year, which we'll talk more about. On the buyout side of the equation, very different market with different characteristics.

Activity stayed pretty strong through the first half of the year, but we really started to see things change over the summer when the debt markets tightened significantly. As debt capital became more expensive and less available, it became a lot harder for private equity firms and buyers of mature businesses to meet sellers' price expectations and raise financing to complete deals.

And that drove a sharp decrease in the total volumes of deals that we saw. But in contrast, the valuations of existing private equity portfolio companies and portfolios and funds overall, actually held up very well through the year. In fact, many people surprised a lot of valuations actually increased during the year, in part because we saw continued increases in earnings in a lot of these businesses.

And the increase in those earnings really offset the valuation multiple compression driven by public comp. So, in both venture capital and buyouts, as we got later in the year, both saw sharp reductions in transaction volumes, but the big bifurcation is VC valuations came down, buyouts held consistent, if not moved up slightly.

David Lebovitz:   Got it. Very helpful. And I think kind of flies contrary to what a lot of people believe. You know, a lot of folks that I talk to are, oh, well, you know, the valuations, they've started coming down, or they need to come down. And what I'm hearing you say is that on the buyout side, the earnings growth was actually there helping them to "grow" into some of these valuations, which folks weren't necessarily expecting.

Ashmi, moving over to you and sticking with the outlook, can you talk a little bit about the backdrop today? You know, 2022 was an okay year for fundraising and investments, but a relatively tough year for exits. And, you know, I'd just love to get a sense of what you're seeing in the current environment, and in particular, how changes in the financing environment that Stephen alluded to in the opening question, what does that look like today, and how do you see that impacting activity overall?

Ashmi Mehrotra:   Sure, happy to address those points. So, just to stick with the buyout activity for a second, Steve talked about how the buyout activity has slowed significantly. We started to see that really in the middle of 2022, and it was really due in large part to the lack of availability of leverage, as we talked about, particularly on the largest end of the market in terms of those large deals, and clearly the higher pricing of leverage given the rapid rise in rates since March of 2022.

So, transaction volumes have fallen sharply. There is a bid-ask spread, as we talked about a little bit, given buyers want to make their target returns and given the higher cost of capital versus what the price expectations are across the board. And so, many sellers are holding price or not selling if there is not a need to at the current time.

That being said, there are new deals that are getting done. They're taking more time. They do have less leverage based on what we talked about already, which by the way, increases our deal flow for co-investments. And there is more pressure on margins, right? Given the broader macro slowdown, there are overall pressures that remain on a macroeconomic level that's affecting companies.

So, due to these factors, entry valuations are coming down in many cases, but there is also this general flight to quality, right? There are more resilient business models. If there's less noise in the pre and post-COVID numbers, those types of deals are getting multiple private equity firms that are looking at them in some cases, and those deals are able to get leverage, albeit less than what was available before.

And if you look at the structures of those deals and how they're getting done, we're seeing more structure. And what does that mean? In some cases, there are levels of milestone payments or earnouts where, you know, some part of the purchase price is paid only if the company hits certain levels of profitability, for example, within certain timeframes.

And we really hadn't seen a lot of that in the last peak in 2021 and early 2022. Lenders are more cautious in general. They are focused on free cash flow, like actual profitability and cash flow and net income versus what they were potentially looking at before, right, overall growth rates and a lot of adjustments in many cases.

And so, the other thing that we're going to see more of and are starting to see more of in terms of deal flow is corporate carve-outs. There is margin pressure, right? We talked about that in general. That is on the large corporate side as well. And we would expect private equity, general partners, and investors, be more active in taking out some of these non-core divisions or whatever it may be as a corporate carve-out.

And then in general, as we're modeling out, what do we do from here in terms of earnings growth going forward? We're generally forecasting, in many cases, lower earnings growth relative to the last few years, longer hold periods, and lower exit multiples, right, on the exits as well.

So, overall, deal activity is slowing, but there are pockets of deals that are being done, but they look a little bit different, and rightly so than what was taking place over the last couple of years.

David Lebovitz:   Yes, it's amazing what getting rid of free money will do for deal activity, and that's going to be something that I think is with us going forward. We've spent a lot of time thinking about what the endgame looks like for these central banks. And while we do believe that eventually, labor markets will deteriorate to the point where they begin to cut, it seems unlikely that they ease all the way back down to zero, which again, to your point, just creates an environment somewhat different from the one that folks got used to operating in during the better part of the prior expansion.

Steve, coming back to you for a minute. So, we just mentioned carve-outs, and that kind of got me thinking that from a strategy perspective, what makes sense to you in this environment, given the focus on quality, given the focus on cash flow? Do you have a preference for small deals relative to large deals? Are there any sectors that look particularly interesting?

It feels like the obsession with tech may be running its course. And then in terms of the actual strategy of the fund, do you have a preference for add-ons and platform creation versus traditional buy-outs? What does the approach look like, given the backdrop that we've laid out here?

Stephen Catherwood:   Sure. So, on the buyout side of the equation, we continue to like the small and mid-end of the market. At the end of the day, that's a segment that requires less leverage to get deals done. Generally, you have an opportunity to buy those businesses, sometimes at lower purchase prices.

There are oftentimes, in these smaller businesses, more ways to fundamentally transform them through professional ownership and bring the private equity value creation toolkit to bear in ways that can make a very significant impact. But within that, the comment about less leverage being one of the attractive attributes, that's particularly key in this market, because when we do start to see the bid-ask spread narrow and sellers capitulate more, firms that don't need to put together very large debt packages, both in terms of multiple cash flow, as well as just the absolute dollar size of those debt packages, they will have more opportunities to find financing partners, get transactions done, and take advantage of those opportunities.

So, we think that's a better place to play, and that's been our view for a very long time. And if deals are closed and then there's more volatility in the market, better have capital to work in companies that have got more cushion on their balance sheet than others that are sort of levered at much higher rates, in our opinion.

So, that's the end of the market where we focus, and we like to find opportunities. To your point about platforms versus add-ons, we have been focused on strategies that have an industry consolidation or buy-and-build component to it for some time, and continue to like that in this market for a couple of reasons.

Ultimately, the market for what we would refer to as platform companies or the large initial transaction or business you would buy in a particular space to support a thesis, those larger companies have generally been more expensive to access with more competition.

Whereas the add-ons, the smaller businesses that might not have as competitive of a process around it, might not have the nice bow put on it by an investment bank as they take it to market, they're generally more work to get those deals done, but you can generally buy them at lower prices.

And if you can add them into a larger platform, there's generally synergies and other opportunities you can take advantage of. So, in a high-price environment, we like that as a strategy because you could essentially average down or blend down your all-in effective entry point, but then add scale, add capabilities, and build out your platform and your business faster than you might be able to just buy one standalone business and trying to grow that in isolation.

So, that's a strategy that we think is an area that can create a lot of value. And if the market continues to get tighter and prices continue to reduce, you also have the ability to blend down your entry price, not only because those smaller deals trade generally at lower multiples, but if all market multiples at all segments continue to trade down, you've got more dry powder to buy into those lower priced businesses.

So, overall, that, we think is a very defensible strategy and one where the private equity toolkit can come to bear in a lot of different ways. From a sector standpoint, we're really looking for areas that have very defensible and resilient earnings. We're certainly not alone in that regard.

But ultimately, with the macro uncertainty and the potential that the change in interest rates and some other macro factors could put pressure on earnings for long periods of time where certain businesses that are more GDP-sensitive are less interesting to us than others that are non-correlated or have very defensible characteristics.

If we switch though from the buyout side to venture, what are we looking for today? We're still very focused on the early stage. We just believe that you can find the very best VCs that have access to the very best young companies. The loss rate in that segment of the market is higher, but the winners can generate outsized returns.

When you look at the early-stage market today versus the late stage, one of the issues that the later-stage companies have to deal with is, they've really had to transition from an environment in 2020 and '21 and part of 2022, where the mindset was growth at all costs. Capital was plentiful. You could raise a lot of money. You could burn a lot of cash.

If you were showing growth, you were rewarded for it. And the mindset has really shifted pretty significantly to one where people are focused on unit economics, reducing burn rate, path to profitability, and those are very significant changes.

And so, focusing on the early stage segment of the market where those companies are tackling what they view as compelling opportunities today without necessarily having to go through the challenges of those repositioning and focus their attention on whether it's artificial intelligence or other tactical opportunities where they see huge growth, we think that's a good place to play and where we continue to focus.

So, in both segments, these are not shifts for us that are necessarily ones we are making today, because they're areas where we focus continuously in part in anticipation of choppier waters which took longer to arrive than we thought, but we appear to be facing that.

David Lebovitz:   No, that makes a whole lot of sense and very helpful. Maybe I'll try AI the next time I have to come up with questions for the podcast and see how that goes. But what I'm hearing from you is that it's about cash flows, stability of cash flows, economic moats, really just - and preserving optionality, right, hitting singles and doubles rather than trying to swing for the proverbial fences.

Just to wrap things up here, I want to take a bit of a turn away from where the conversation's been thus far, and Ashmi, bring you back into the conversation. So, secondary strategies have gotten a lot of attention. I feel like every large alternative asset manager has raised the secondary fund so far in 2023.

I would love to get a sense from you what you're seeing in terms of activity and opportunity. And then furthermore, do you see a difference between GP-led and LP-led secondaries? And finally, any thoughts you have on co-investments would be appreciated as well. That came up earlier in the conversation, and I'd love to just flush that out a little bit further. So, within the newer area of the private equity world, what are you seeing across secondaries and co-investments?

Ashmi Mehrotra:   Sure, happy to talk about each of those areas. So, the secondary market has grown significantly over the past, call it 10 years or so, right? Just to put some numbers around it. In 2012, it was about a $27 billion market. And last year, 2022, it was close to $110 billion.

And that includes transactions both on the GP-led side and the LP-led side. It was actually split pretty evenly across those two across the past two years. The secondary market, you are right, in private equity is very active right now. This is largely due to the over-allocation of many limited partners in the asset class.

And sellers include corporate and public pension plans, endowments, family offices, a whole host of different types of sellers. And we are seeing strong activity and pricing so far. And just to put some numbers around it, we can get 10% to 15% off, if you will, for buyout funds, call it you're paying 85%-ish of 9-30 and 12-31 NAVs for buyout funds, and about 60% to 70% of NAV on the venture capital funds.

And the key question you have to ask is, okay, well, you're getting 35% off on whatever fund you're looking at, but what is the NAV? Is it real, right? We talked a little bit about the valuation lag earlier, but really it is imperative to look at the underlying portfolios to determine, is that the right valuation of the portfolio, number one, and then what are the key drivers going forward in terms of how are you going to make your return, regardless of what type of discount you're getting.

And so, we like to say, yes, the market is very active for the reasons I talked about, particularly overallocation, but also you have to continue to be selective and do your homework on a bottoms-up basis on the portfolio itself. Some GPs are more aggressive on valuations, some are less aggressive, some are a little bit more conservative.

So, it's imperative to figure that out and then look at what is the forecast going forward. To answer your question around GP-leds versus LP-leds, they are quite unique. So, we have done some GP-leds as well. It's a very different part of the market, and I'll go into some of the positives and negatives.

Certainly have to be selective across both GP-leds and LP-leds, in our opinion. On the GP-led side, on the positives, there's new investors that can get into high-performing companies that are not in the existing portfolios yet by, in many cases, proven strong GPs that have good value creation plans remaining for those portfolio companies.

So, new investors can get access to those. LPs in the existing fund have an option to cash out because there's a new investor coming in, or they can roll into the new vehicle. So, it creates a new exit option that didn't really exist before, right? So, I think that's a potential positive if you're looking on the sell.

And then GPs can get additional time and capital to continue to grow what I'll call "trophy assets." Now, they're not all trophy assets, which is why you have to be quite selective, but there is that potential positive. And then there are - as in everything in this world, there are negatives as well.

So, there's potential for conflicts of interest, right? The sponsor, the GP, is on both sides of the deal. In many cases, there's limited third-party pricing. So, we have to be very careful there in terms of, is it an arm's-length deal? No, but are there outside valuation confirmation, which would be important.

The other thing that we have to be careful about is alignment. The GP and management teams sometimes are cashing out of these portfolio companies or these positions, and we obviously want to see strong alignment going forward. And then there's an unfunded commitment option as well, which can be quite problematic for the existing investors.

If you're an existing investor, you want to roll into the new vehicle. Sometimes you have to put up new capital on an unfunded basis to continue kind of the roll-up program or whatever it may be. And some of these vehicles are very old, and those LPs or those vehicles may not have that level of unfunded commitments going forward.

So, I think there are certainly positives in terms of getting exposure to certain types of companies within the GP-leds, but obviously, you have to be cautious there as well. On the co-investment side, to answer your question there, we're seeing good deal flow. There's obviously slower deal activity in general, as we talked about, but we have done some interesting deals this year, particularly from general partners where we are not a current investor in their primary fund, which is a little bit counterintuitive.

It's like, well, why are we seeing those deals? Part of it's because we can be a large primary investor, right, and there's no obligation to look at or do their next fund, but there is the potential to close a private equity group into that next month. I think that drives some of it, but also there is less leverage available, right? They have to put more equity behind these deals.

And so, there is a potential to have more co-investments around that. And by the way, those can be at attractive fee structures as well. Again, we need to be highly selective given the macro backdrop, right? There is earnings pressure in various areas of the economy and segments of the economy, and there are opportunities to take advantage of the dislocation and uncertainty that currently exists.

And so, GPs are not coming back with their next fund anytime soon in many cases. They want to extend their current investment periods as long as they can. And so, that will also lead to, we believe, doing more deals to round those funds out and more potential co-investment in those deals.

David Lebovitz:   Excellent. Well, guys, this was fantastic. Thank you so much for taking the time to join me on the podcast today. I think we unpacked a lot. We covered a decent amount of ground. And I think we hopefully gave all of our listeners some interesting things to think about as they allocate assets to private equity funds over the remainder of 2023.

So, thanks again for joining us, and looking forward to having you both back sometime again soon. Thank you for joining us today on J.P. Morgan's Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our Web site. Recorded on May 17th, 2023.

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