Marc Syz, Co-Founder, Syz Capital
Financial history will remember 2021 as an extraordinary year for risk assets. Even if less visible than public markets, the year was significant for private equity, in terms of deals closed, valuations paid, and exits, including high-profile technology IPOs.
Moving into 2022, we expect growth to remain healthy, but much of this is already priced in. Asset allocators will need to position themselves intelligently to capture the idiosyncratic returns that private markets can generate and not be misled by an apparent portfolio diversification that often simply doubles down on expensive risk premiums already present in their public portfolios.
Private markets enlarge and enrich our investment universe by offering investors access to attractive assets and companies that are not available in the public domain. They also allow investors to take a longer view, while avoiding the pitfalls of short-term thinking and poor decision-making when faced with market-to-market volatility.
Less efficient private investments can reward diligent investors for thorough analysis and well-executed value creation plans. Finally, they allow investors to participate in success stories before such growth normalises.
Cryptocurrency aside, we expect the Nasdaq to be the clear winner of 2021. As success attracts success, most investors plan to increase their exposure to technology, but also realise that listed tech companies are only the tip of the iceberg.
As companies stay private for longer, investors may seek exposure to high-growth companies before they go public through an IPO. But the more they wait, the more valuation risk increases, especially in today’s cash-flooded environment. On the other hand, early-stage investing includes significant business and duration risk, which can only be mitigated through adequate diversification and the availability of follow-on capital.
The right balance is probably somewhere between the two, but access to such opportunities requires specialised skills and networks. Building a private market portfolio to spread risk across vintages takes time and discipline. No crisis or euphoria should side-track investors from achieving their strategic asset allocation goals. However, depending on the macro environment and valuation landscape, allocators may favour some more attractive segments.
When there is ample liquidity and intense competition for deals, we spend time and resources on succession issues in family businesses, or disposing of non-strategic assets. Complexity and small transaction sizes enable us to enter deals at more reasonable valuations, limiting our capital at risk. In the context of market cycles, distressed investing is interesting. Record amounts of money were raised in the darkest days of the lockdown from a wide range of global allocators. Some were disappointed by short-lived opportunities with shallow volumes.
Very few investors had time to accumulate quality assets at low prices before the first vaccines, and subsequent recovery hopes killed the trade. Nor did the anticipated bankruptcy wave materialise either, as moratoriums were imposed in most jurisdictions, preventing companies from filing. As these are lifted, selective opportunities may arise. Despite this, we managed to take advantage of crisis-generated opportunities throughout the year, especially in our litigation funding strategies where we finance an increasing number of insolvency and business continuity claims. We believe this is one of the most compelling ways to benefit from the crisis with no market exposure, and is another good example of diversification.
Meanwhile, we see value in alternative UCITS funds. Their lower expected returns, mainly due to less leverage and concentration than classic hedge funds, are compensated for by better liquidity. This flexibility allows us to be more trading-oriented when managing an alternative UCITS fund portfolio. Finally, we remain convinced of the value of convertible arbitrage and merger arbitrage strategies that can provide diversification, due to their lack of correlation with the wider market.
Anna Morrison, Senior Director, Private Markets, BFinance International
Strong secular trends will support growth in impact private equity in 2022 and beyond, with increased accountability at the corporate level for net zero commitments and PRI signatory
status, for example, coupled with ongoing and increasing regulatory requirements.
There is more clarity that impact investment is no longer a concessionary asset class, which clears one hurdle. LPs are now moving onto different considerations, such as where impact strategies fit within portfolio construction.
We are also seeing a number of traditional fund-of-funds groups raising funds dedicated to impact investing, alongside a group of specialised providers. This speaks to the growing maturity of this segment.
Among specialist managers, we are increasingly focused on the impact sector as a growing area of interest for clients. The expanding, broad range of investment options and providers position this sector as a sensible addition to a diversified private equity portfolio.
We are also witnessing increased investor appetite for venture capital given the strong performance of this asset class over recent years and particularly during the pandemic. This space must be approached with caution, particularly for those investors who are new to the asset class and lack existing relationships. This area of the market is best addressed initially with the help of specialist fund of fund providers, so we expect to see continued demand in this space.
We also envisage continuing high demand for secondary strategies, both from investors with established private equity programmes and those new to the asset class. Newer entrants to private equity find this space particularly appealing, due to the reduced j-curve, the faster path to a highly diversified portfolio (vintage, geography, strategy) and the earlier distribution profile. The maturity of the secondaries sector has also helped to address some of the traditional pain points felt by LPs in standard fund of fund models.
We’ve seen a shift in global fund-of-fund allocations, with managers moving away from primaries (although this generally remains the largest overall allocation) and towards larger allocations to co-investment and secondaries. As well as allowing fund-of-funds to provide investors with a more ‘secondaries-like’ cash flow profile, these give managers more opportunity to gather performance fees, since the market is moving away from charging performance fees on primaries.
Over time, we see knowledge transfer forming an important part of the offering from fund-of-funds, and expect this to continue into 2022. Knowledge transfer capabilities have come a very long way in the past decade, and demand from our clients continues to increase, particularly for first-time investors who wish to build out programmes, and investors seeking to insource management gradually over time.
Many fund-of-fund managers have now acknowledged that knowledge transfer needs to be part of their servicing in order to remain competitive and that this should be highly tailored – even for smaller investors. This can range from tailored education services right through to providing GP introductions and direct access to funds outside of the existing fund of fund relationship.
Nick Samuels, Head of Manager Research, Redington
Instead of looking to race onwards like other funds in the sector, we’re simply looking to find the best ideas in 2022. We have a 25-person manager research team, which is large by industry standards. We’ve really invested in our research to make us stand out and we try to hire people from within the industry.
We look for practitioner experience so that the person can bring their industry knowledge while learning about how to conduct manager research. So, when they’re talking to a fund manager, they speak and understand their language, as well as the markets themselves, and they understand where fund managers might be looking to pull the wool over your eyes. We employ people who used to be high-yield fund traders, rates traders, and previous chartered surveyors.
In 2021, we saw private equity perform incredibly well, and clients like it; it’s often as simple as that. We saw a high interest in private credit specifically, which we expect to continue and grow. It’s a big theme across our pension fund clients’ portfolios, since this part of our client base isn’t necessarily interested in private equity as most schemes have an end point. A private equity investment is something that our clients have previously had, but they’re not looking to make any new investments in the near future.
However, private debt is different because the cashflow is ideal for a pension scheme. Within this, we’ve witnessed increasing interest in opportunistic strategies within our client base. We’re continuing to research broader private market strategies as well, since we have different sub-aspects of the client base, including endowments and wealth management. Here we expect impact private equity to be of interest, in particular.
This past year, we’ve done a lot of work on impact strategies to invest in more sustainable solutions. We focused on renewable infrastructure, private equity and private debt impact. We’re also working on natural capital and developing that too.
We assess every manager on how well they integrate ESG into their investment process. We’ve worked on this for a few years, and we’ve also been thinking about getting all portfolios aligned to net zero. In April 2021, we made a commitment to align all of our client advice to net zero, and to take our own business to net zero too.
In 2022, we’re looking to work with the asset management community to encourage them to align their portfolios to net zero.
We’re trying to impress upon them that all funds should align to net zero, so our advice is not to launch a brand-new net zero version of your existing fund, given all funds will have to get to net zero. We’re asking them to get ahead of that if they’re going to continue running our client assets. What that means to us is putting in a constructive plan. Are you going to bring about a 50 per cent carbon reduction by 2030 – if so, how are you going to do this and how are you going to engage with your underlying portfolio companies? The conversation is live and is part of a bigger industry trend.
We think allocations to Chinese equities are very sensible; it’s very underrepresented in broad market indices and there’s a strong top- down story behind allocating to it, as well as a strong bottom-up alpha story. But, quite rightly, clients have expressed their concerns from an ESG point of view. There have been a number of regulation issues, and a lot of negative press. You rarely make money from investing in things which are comfortable, but we’ve definitely noticed a push-back from clients on these investments in the past year which indicates a reluctance for these types of investments in 2022.
Colin Murfit, Director of Research, Alan Biller and Associates
In 2021, we primarily focused on North American upper-middle market private equity funds, and we’ll continue to do so in 2022. We think this market has the most depth from a GP perspective, and we also think the US middle-market is an attractive place to deploy capital from a risk-adjusted return perspective.
Our client demand for private equity remained relatively consistent across the pandemic and 2021. Target allocations have not increased significantly in recent years and over the same period, we’ve also seen significant amounts of distributions out of our client private equity portfolios. But it’s no secret, private equity GPs these days are returning to market at a brisker pace than the historic norm.
We think we will see ongoing growth in single-asset continuation vehicles in the coming year. In addition, one trend I think we may see more of in the future is greater adoption by LPs seeking to sell portfolios of PE fund interests using alternative methods for liquidity generation, rather than an outright traditional portfolio secondary sale.
The most notable of these alternative methods for liquidity generation are structured capital solutions, where an owner of private equity fund interests generates liquidity by financing the portfolio (effectively borrowing and using the portfolio as collateral), rather than outright selling the portfolio in a traditional secondary sale transaction. Currently, Whitehorse Liquidity Partners and 17 Capital are the best-known GPs in this subset of the secondary market, but I anticipate we will likely see greater adoption of this alternative solution to a traditional outright sale by more secondary private equity fund managers in the coming years.
In terms of our due diligence process, we place a very heavy emphasis on evaluating portfolio company-level data for the GPs with whom we partner, and we have a robust proprietary database of portfolio company metrics which we request our managers to update every quarter. This includes key operating performance metrics for each portfolio company in their portfolios. Having access to this data allows our investment team members to readily assess the revenue, EBITDA and leverage profile of each portfolio company held in a GP’s portfolio, and how those metrics have evolved over the holding period.
In terms of our approach to investing in the asset class, we don’t seek to be tactical and time individual subsectors of the market, instead we focus on picking best-in-class GPs who we feel will perform well in an all-weather environment. LPs can’t control the market environment, but they do have control over the quality of the GPs with whom they select to partner. Our programme is primarily focused on established GPs. That said, we are certainly open to meeting with emerging GPs and, under the right circumstances, we would not rule out backing an emerging GP.
In terms of whether to invest with sector specialist GPs or generalist GPs, we tend to be fairly agnostic on this question – however we must ensure we are cognisant that we’re not over-exposed to any one given sector in our overall client private equity portfolios. There are arguments in favour of generalist funds, but also in favour of sector specialisation. In reality, most generalist funds tend to focus on three to five sectors. These decisions are best made on a case-by-case basis, and there is no right or wrong answer to the question. We don’t explicitly allocate to ESG-focused private equity funds, however, it’s certainly an overlay in our process, and we seek to ensure our GPs – and their underlying portfolio companies – adhere to current best practices and behave as good corporate citizens. Our firm is a signatory to the UN PRI.
Todd Silverman, Private Markets Consultant and John Haggerty, Director of Private Markets Investments, Meketa Investment Group
As we look ahead to 2022 and despite expected continued uncertainty and inflated asset values, more than anything else we expect to stay the course. We recognise that private equity is a long-term asset class and believe investors are generally best served by maintaining a long-term view, and not trying to time the market. With the growth in fund sizes, accelerated deployment, greater competition, mounting dry powder and high prices, we are doubly focused on risk and ways to mitigate it, via hands-on capabilities, alignment with GPs and pricing discipline.
Investing with top managers remains critical, and many of the traits we seek in those managers have not changed – these include team continuity, strong track records, defensible advantages in the market and a demonstrated ability to add value. Managers themselves must remain nimble and willing to evolve. The successful firms of tomorrow will innovate and find new ways of adding value with specialists in recruiting, capital markets, and other areas.
Though we still see room for generalist strategies, we consider sector expertise as logical and appealing in an increasingly competitive market. This is particularly true in niche, regulated and trend dependent sectors like healthcare, technology and consumer. We remain interested in venture capital strategies, including life sciences, and expect technology to drive investment opportunities and returns, supported by accommodative public markets, and despite lofty valuations.
Of course, we will always need to adapt to new opportunities and challenges. Capital deployment continues at a rapid pace and fundraising cycles are compressed. Previously, GPs typically raised new funds every four or five years, but today they may return to market after two years. As a result, some investors may seek to revisit exposures and focus attention on a select group of core managers.
Additionally, exceptionally strong private equity performance over the past 18 months has many programmes at the top of their desired allocation ranges. We expect this to further the trend towards finding liquidity solutions – either through GP-led fund restructurings, or more targeted use of the secondary market. Until recently, secondary pricing seemed to largely favour sellers over buyers. More recent signs now show a better balance of supply and demand.
Lastly, we see increasing opportunities for LPs who focus on ESG factors in their research and on emerging managers. ESG is no longer a specialised part of the market, but rather it’s recognised, at both the investment strategy and firm level, as an avenue through which to create value. Similarly, emerging managers are the future of the industry and very often offer better alignment with LPs with respect to economics and motivation. While the desirable characteristics for successful managers have not changed, the profile and composition of those teams will continue to evolve. As always, relationships and manager selection remain paramount.
Carlie Eubanks, Investment Director, and Taylor Jackson, Investment Director, Verger Capital
No one can accurately time the private markets. Our goal is to be consistently invested in top funds over time, across sectors and vintage years, and throughout market cycles. This requires that we develop relationships with top firms early and continually cultivate them to give us access when those firms are back in the market.
Within private equity, we tend to focus on the lower middle-market, investing in smaller funds, typically those sized USD1 billion or below. We believe this area of the market is less efficient, with fewer firms competing for deals and companies that are at the size and stage where managers can truly add value by professionalising and preparing them for the next level, such as acquisition by a larger private equity firm or strategic buyer.
With regards to venture capital, our emphasis is skewed toward early-stage funds that are often led by former founders and operators themselves. We believe these individuals possess the skills to support their start-up companies from an idea, through product development, team building, market identification, and scaling the company to exit.
Valuations are at all-time highs, and the secondary marketplace is no exception. Private equity secondary markets are fully priced, and the spread between venture capital secondaries and private equity secondaries is tightening. We expect to see this continue into 2022, as more investors seek venture capital exposure.
We look for managers who have a unique edge in creating value and who grow their portfolio companies in a consistent and repeatable fashion, regardless of whether the firm is specialised in a specific sector or works more as a generalist.
We have a track record of investing with emerging managers, including many first-time funds, which we expect will continue. We are always eager to identify new talent and opportunities that are differentiated from our existing manager relationships. However, new or emerging managers must compete for allocation with more established firms with longer track records and histories of success. In our review and selection of managers, an emerging manager goes through the same rigorous underwriting process as an established manager.
We start with the view that the consideration of ESG issues in our business and investment decision-making is consistent with our duty as a fiduciary and consistent with what our clients expect of their OCIO. As an OCIO, we allocate capital to external managers. Before hiring a manager, we perform substantial research to determine if the manager has the skill required to provide the desired investment outcome.
Environmental, social, and governance (ESG) dynamics can influence the risk and return characteristics of a manager’s strategy. Adding an assessment of ESG factors into our manager research process, with a materiality-focused approach, gives us a more thorough understanding of the complex issues and drivers of risks that may impact our managers’ portfolios over time. We believe this allows us to make better investment decisions. Because we invest in a manager and not simply in its strategy, our research includes an assessment of a firm’s operations and culture. Here, too, environmental, social and governance issues could influence the manager’s ability to build and manage a sustainable business, so we consider ESG issues in our operational assessment.
Overall, we are focused on engagement with our managers, which recognises the adverse ESG qualities in a manager’s investment strategy or operations and the potential for improvement and growth, and creates plans to work with these managers rather than to not initiate or terminate an existing relationship.
Chris Shelby, Director, Private Markets, Verus
We deploy a little over USD2-3 billion per annum across private markets, including private credit, private real assets, real estate, and private equity (which also comprises venture capital and growth capital). Private equity is always topical with our clients, but often for differing reasons.
Leading into the pandemic, interest in private equity was very high because we were seeing expected returns of the traditional markets continuing to decline, and a very low interest rate environment, as well as liquid equity markets which have remained strong over the past decade.
Within buyout and venture capital strategies specifically, we have witnessed a rapid increase in exposure to technology-based companies, given their prevalence across many end markets. In some cases, this has debatably resulted in an overweight to technology. We are aware of this exposure and in many cases are seeking to find opportunities that may be less correlated to the valuation factors of technology companies. Our focus remains to identify the groups that have a fundamental reason to acquire a company and really improve it; they play an active part in this and have operating networks in place to make the company grow.
Private credit is an area where we’ve seen a tremendous amount of interest, in part because of the lower interest rate environment and tight spreads offered in the traditional fixed income markets. Portfolios that entered the space as a yield enhancement to traditional fixed income are looking to broaden their exposure to a diversified mix of strategies. These may include more opportunities strategies, as well as those that may offer an element of diversification from a collateral perspective. As many clients have grown to include distressed debt strategies within a private credit portfolio, we’ve found that this space may experience headwinds due to the tremendous amount of additional capital that has been allocated to the space in recent years, combined with the somewhat benign market conditions. Opportunities remain in strategies seeking to provide transitional or situational capital to companies that may be suffering from an idiosyncratic event.
Private credit portfolios are also considering more niche and possible credit-like strategies including royalty-based strategies, litigation finance strategies, portfolio finance, and various other real asset lending strategies. These typically have very different return and risk profiles from traditional corporate-focused strategies but may offer an enhanced level of diversification at the portfolio level.
With regards to ESG, these standards are incredibly important to Verus and to our clients. We integrate an ESG evaluation into the initial screening of private markets firms, followed by a thorough review in further diligence. However, we’re aware that you must be wary with ESG, because many will approach the topic and claim to adhere to the principles, but ultimately their portfolios may not back this up.
Additionally, sound adherence to ESG standards does not necessarily result in the achievement of excess returns, therefore the diligence process must balance the ESG review with other investment criteria.
