Private market investing adapts to the current environment, insights from the SuperReturn US West 2019 Conference

In an effort to share knowledge, the following includes insights and my takeaways from the panels and presentations at the SuperReturn US West 2019 Conference last month.  It was an honor to present at the Fund Showcase, but it was more interesting to learn from the rest of the attendees.  Presentations which contributed to my notes and thoughts came from the following: LACERA, Coller Capital, Headlands Capital, Darc Matter, Muzinich & Co., Dr. Jerry Nickelsburg, The Port of LA, Probitas Partners, Alpha Venture Partners, Preqin, Upfront Ventures, amongst others.

The number one referral source traditional limited partners (LPs) rely on is other LPs.  Other sources include other GPs, fund formation attorneys, placement agents, and service providers.  Relationships are crucial to finding asset managers, and for asset managers, or general partnerships (GPs), relationships are crucial to be able to raise assets.  LPs do not rely much on databases like Prequin and Pitchbook as relationships matter more.  GPs must navigate the LP ecosystems to be known and consider developing their own ecosystem through thought leadership and relationships. 

It’s okay for GPs to take seed capital as first-time funds are really difficult, but don’t be beholden to anyone.  Independent, or fundless, sponsors, should be open to taking seed capital.  Approximately 30% of GPs are open to anchor/seed deals.  Anchor investors, however, should probably not be involved in the investment process.  But not worry, GPs always remember their founding LPs.  GPs can also consider sharing the opportunity to seed with other LPs, not just the anchor. Some LPs prefer not to have anchor-type LPs who may be perceived as having outsized influence on the GP. Regardless of who you are and where you come from, first-time funds are difficult to raise.  GPs must prepare to fundraise for one to two years, if not a lot more, to raise a new fund.  If you’re a fundless sponsor, work on telling a legitimate story and bring a deal – an LOI on the first deal doesn’t hurt.  The good news for fundless sponsors is that 89% of investors who have more than $500M committed to private equity (PE) also have an active internal co-investment program or outsourced one, according to Probitas Partners.

New differentiated strategies in first-time funds are not as welcome in the industry as LPs prefer to see a track record in an existing strategy – oh and it doesn’t hurt for the GP to already be wealthy.  LPs generally like when wealthy partners at GPs backstop younger partners – younger partners are usually given the ability to earn out the wealthier partners’ backing.  LPs generally want 1) a cohesive team with a track record in the asset class, 2) a repeatable investment process, 3) the ability to source deals, 4) strong pedigree, 5) prior institutional investing experience, 6) portable track record, and 7) the ability to sustain themselves – essentially wealthy already.  LPs also like being asked about their own strategy – do not forget the personal side of the business.  In addition, GPs should ensure that every team member meeting with an LP has a specific role and unity is displayed. 

PE fundraising continues at a strong clip, however, big buyout fundraising is slowing.  LPs realize mega funds will have a tough time with exits.  Final closes for non-buyout funds, however, continued to increase, especially for middle market and growth capital raises.  The lower middle market uses less leverage, which leads to lower loss and default rates.  In addition, there is way more private equity dry powder than private debt supply, which leads investors to believe more will be deployed to credit in the coming years.  LPs also seem more and more to like operationally-focused funds and funds focused on healthcare and technology.  LPs understand the market currently wants growth over profitability and sometimes the best PE performers are startup funds. 

LPs care about returns, however, environmental, social, and governance (ESG) factors, including diversity, are starting to be recognized.  The Institutional Limited Partners Association (ILPA) is finally putting ESG at the top of mind.  Some institutional investors have begun treating ESG as part of their fiduciary duty since circa 2013 when studies began touting correlation between corporate sustainability and strong financial results.  LPs think of diversity more broadly than skin color and gender and consider factors such as what makes people think a certain way.  It is as if diversity finally came into vogue, but skin color and gender was too difficult to accomplish, so folks decide to broaden the definition. 

Valuations are the number one concern for investors when considering PE return expectations.  Exits need to be planned at entry with the understanding that strategic buyers care about different things than financial buyers.  A strategic buyer looks for a product/service that it can sell to existing customers while financial buyers will buy based on financial health and opportunity for future returns.  Aside from exits, Partners Group considers the following value creation levers: accretive acquisitions, strong direction from board, cost savings, new customers and partners, end market expansion, new product launches, strategic planning, talent management.  Technology enablement was not a stand-alone value creation lever considered.  Given LP concerns and other market factors, the market is expected to see more 1) GP stakes by investors to enhance and diversify PE return streams, 2) secondaries investing in order to eliminate the beginning of the PE J-curve, and 3) take-privates potentially converging private and public equity returns. Concerns include GPs selling companies too early to show realizations for fundraising and frequent sponsor-to-sponsor deals resulting in transaction fees borne by LPs.  Despite all this, LPs believe PE-backed companies will perform better than non-PE-backed companies during the next economic downturn.  Lastly, LPs are not increasing focus on any one particular industry.

More LPs are now looking to buy and sell secondaries.  Secondaries are a three-party structure and can create win-win-win situations.  While previously viewed negatively for GPs, they are becoming more commonly accepted these days. Some VCs are still pretty secretive about their secondaries.  The current dynamic, though, is that GPs need to show exits, LPs desire liquidity, and of course secondary investors seek opportunities.  It’s a “3-ring circus” which you don’t want to get out of hand.  There is an argument for over-concentration into smaller amount of deals to be selective, but the fact is the market is growing for secondaries.  However, buyers know that well-run auctions will not allow for good pricing.  If everyone knows who is involved, buyers may not buy, so there is an interest in the seller to not allow a lot of people to know about their secondaries.  LPs are weary of single asset secondaries because of the concentrated risk.  There are $330 billion in “sunset funds,” which used to be referred to less politely as “zombie funds.”  While there may not be a lot of secondary funds raised, more and more investors say they do “GP restructuring.”  Capital is there despite the lack of dedicated secondary funds.  GP liquidity solutions tripled in the last four years according to Evercore, and now constitutes nearly a third of the secondary market.

Dispersion of VC fund IRRs is narrowing as lower quartile VCs are performing better than their historical performance and top quartile VCs continue performing on par with their historical performance according to Preqin.  This could potentially be that good deals are becoming more available outside of Silicon Valley or outside the top firms in Silicon Valley.  In addition, it is interesting to note that first-time VC funds are outperforming non-first time VC funds.  The hunger to ensure strong performance is found more in first-time funds.  Pre-seed (<$1M) deals have cooled off, decreasing year-over-year for the last 3 years, versus growing over 6x from 2006 to 2014.  Seed ($1-5M) deals similarly have cooled off as they’ve also decreased year-over-year during the last 3 years vs growing over 3x from 2006 to 2014.  Fewer micro funds are being raised over the last 3 years as “early stage” funds are bigger now.  Companies are staying in the seed phase longer as time to Series A has lengthened from less than 1yr in 2011 to 1.6yrs in 2018.  And yes, valuation creep is happening.  One reason is that VCs try to invest pro rata on their deals to keep the same ownership.  VCs have increasingly set up “companion funds” to defend their ownership.  VCs hope their late stage pro-rata investing will allow them to reap rewards, but the IPO window/liquidity has been pushed out 5yrs on average as dollars have shifted from public to private markets.  This shift leads to more mega rounds and less IPOs.  54 new unicorns were created in 2018 vs the previous high of 43 in 2015, according to Pitchbook.  While tech/internet use continues to broaden globally, VC returns are still on paper.  Larger sized exits are deceiving as the number of exits is actually dwindling to 2010 levels.

Technology needs to be understood by all investors.  While traditionally VCs are at the forefront of technology, investors expect more non-VCs to also understand technology investing and the use of technology in general.  Even real asset investors need to understand the technology used on the asset, whether land or other property, so as to understand the real value that can be created with the asset.  In addition, the most sophisticated investment firms, regardless of size, also have a tough time capturing and analyzing data across their portfolio companies.  This difficulty leaves tons of room for opportunity to improve.  And, do not expect much AI on data analytics or sourcing.  LPs are interested in GPs that have actual differentiated technology.

Talent management includes focusing on culture and ensuring that all employees feel accountable.  GPs should work on having an employee handbook.  Founders need to expound on vision, values, and goals of firm.  Do not ignore team building events and be ready for more questions on diversity.  Lastly, non-competes are difficult to enforce in California.

Vietnam is increasing its share of imports and exports according to LA Port data.  Vietnam is the fastest growing importer for furniture, toys, clothing, footwear, and leather, while Indonesia leads the growth for footwear and Thailand for plastics and auto parts.  Exports to China are decreasing while Vietnam is taking share.  The top imports are 1) furniture, 2) auto parts, 3) apparel, 4) electronics, 5) footwear.  The top exports are 1) wastepaper, 2) animal feeds, 3) scrap metal, 4) fabrics, 5) soybeans.