Opportunities are evolving in a challenging market environment
In brief
Today’s market dislocation has the potential to open up new avenues for investing in private equity (PE).
Market dynamics are creating attractively priced opportunities in the secondary market for private equity assets, as asset owners seek liquidity after public market declines have left them overallocated to PE.
We anticipate a rise of co-investment and unique “stapled” opportunities as general partners seek additional capital to support companies and make new investments.
We believe the long-term outlook for buyouts, particularly in the small and middle market, remains positive.
Within venture capital (VC), early-stage VC continues to be an attractive entry point, offering what we view as the best long-term risk-adjusted returns.
Vintage year diversification remains key and investment selection is critical given the large dispersion of returns between top and bottom quartiles.
Private equity (PE) investments made during and after market dislocations have historically returned well above long-term averages. While we can find attractive PE investment opportunities throughout every phase of a market cycle, the current market dislocation points to several areas of particular interest in the year ahead. However, since performance dispersion among funds remains wide, manager and asset selection continue to be key.
Many investors find themselves overallocated to private equity amid a decline in public markets. Simultaneously, a record number of private equity funds are fundraising. This dynamic creates favorable supply/demand characteristics for investors across a range of PE investment types and strategies. These include discounted assets available in the secondary market, co-investments1 and stapled transactions (primary fund commitments stapled to co-investments or secondary investments).
Market dynamics are creating a resurgence of attractively priced secondary market opportunities
The secondary market for PE assets (or “secondaries”) purchased from the original PE investor looks attractive in 2023 and beyond, for a combination of reasons.
The secondary market remained competitive and highly priced for purchasers through 2021 and 2022. Late last year, however, secondary purchase prices dipped to 60%–70% of net asset value, as limited partners (LPs) were driven to sell (Exhibit 1A, 1B). These transactions are due in large part to the denominator effect: As the value of public holdings deteriorated and PE valuations did not adjust downward as dramatically after years of strong growth, investors became overallocated to private equity relative to their targets. LPs who are overallocated may need to reallocate and free up cash through secondary sales, creating an attractive opportunity for buyers.
As secondary buyers, PEG underwrites LP secondaries of mature and diversified portfolios, employing a bottom-up, company-by-company forecast model. PEG also targets general partner (GP)-led secondaries with single- or multi-asset continuation vehicles.2 We focus on those in recession-resilient companies whose operating models we believe have a higher probability of sustained earnings growth despite a difficult macro environment.
A challenging fundraising market may increase co-investments and present “stapled” opportunities
After five years of rapid fundraising, when PE funds both raised and deployed capital quickly, the pace has slowed, and we expect this dynamic to continue (Exhibit 2). While a record number of buyout and venture funds are still raising capital, volatile public markets, and LPs facing the denominator effect, have produced a more challenging fundraising environment.
We predict that these conditions could lead to an increase in co-investment opportunities, in which LPs invest directly into private companies alongside GPs. Since funds will likely need to preserve more capital in this constrained fundraising environment, and since PE transactions often depend on leveraged loans that have become more expensive, we expect GPs will be more interested in partnering with LPs on transactions.
We also expect to see more stapled opportunities, in which a GP sweetens an investment into their primary fund by structuring a deal to include a co-investment or secondary. Investors will have more leverage to create unique transactions in this environment as LPs pull back their allocations, a greater number of funds are eager to raise capital, and available capital becomes more scarce.
Disciplined, consistent commitments to top-tier fund managers remains key
It is important for investors to stay disciplined in their private equity commitments. Investors facing an overallocation to private equity in their portfolios should contemplate the impacts of vintage year diversification and consider continued commitments, even if at a reduced size.
Diversification matters because although private markets have consistently outperformed public markets, PE returns differ by vintage year, and this phenomenon has historically been heightened following a period of public market distress.
Top quartile funds of vintage year 2009 and 2010, for example, after the global financial crisis (GFC), achieved internal rates of return (IRRs) of over 20%, surpassing even the highest-performing PE funds from 2006 and 2007, vintages that immediately preceded the GFC. A similar pattern presented itself after the dot-com bubble burst in the early 2000’s, and after the downturn in 1990–1991 (Exhibit 3).
We see a positive long-term outlook for buyouts and venture capital
While the future market environment will likely differ from history, we believe that the long-term outlook for buyouts, particularly in the small and middle market, and for venture capital (VC) remain positive, especially in the earlier stages3 of investing. We believe that buyout GPs focused on the small and middle market will continue to have an advantage in 2023 and beyond.
This small and middle-market segment offers a larger opportunity set than the large and mega-market, in its greater number of smaller companies, and its potential to build scale through an ongoing process of buy-and-build. The small and middle market also generally offers lower purchase prices, less reliance on debt financing—which may be harder to secure in the environment we anticipate over the coming year—and multiple avenues of exit (especially with dry powder on the sidelines).
Within venture capital (VC), early-stage VC continues to be an attractive entry point, offering what we view as the best long-term risk-adjusted return characteristics. Though later-stage venture valuations have retreated from their peak, offering a potentially more attractive entry point for growth investors relative to recent years, this segment of the market is still very competitive, and the valuation expectations are likely still too high for most companies.
But early-stage VC opportunities require expert managers. Relative to later-stage opportunities, early-stage venture companies have less certainty around the timing of an initial public offering; about whether certain business models can become profitable and about how much more time and capital the companies will need to reach breakeven.
We believe the highest return potential for VC investing will continue to come from identifying and accessing early-stage VC managers who have, through multiple market cycles, demonstrated success in partnering with the best entrepreneurs to build and exit venture companies.
Conclusion: Positioning for resilience during a recession
The private equity industry is better positioned today to navigate the next recession than it was before the GFC. Managers have acquired more resilient businesses, expecting to own them through tough times ahead. Additionally, the market dislocation has the potential to open up new avenues for investing in private equity.
The secondary market, which has been highly priced and competitive in recent years, is ripe for opportunities as LPs and GPs may be seeking liquidity for assets or whole portfolios. We anticipate a rise of co-investment and unique stapled opportunities as GPs seek additional capital to support existing companies and make new investments.
Finally, vintage year diversification continues to be key, and investment selection is critical, given the large dispersion of returns between top and bottom quartiles. It will be more imperative than ever for private equity investors to remain disciplined, stick to their investment processes, and invest in the highest conviction opportunities.