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The mainstreaming of ‘alternative data’ in private equity

By Yamelin Castillo, Practice Head, Wealth & Asset Management, Lab49 – ‘Alternative data’ has become sufficiently conventional among certain types of professional investors that the term is now something of a misnomer.

By Yamelin Castillo, Practice Head, Wealth & Asset Management, Lab49 – ‘Alternative data’ has become sufficiently conventional among certain types of professional investors that the term is now something of a misnomer.
The unstoppable rise of index investing over the past decade has channeled more and more capital away from active stock-pickers and long-short hedge funds and into passive strategies. Notwithstanding the recent bursts of market volatility triggered by the pandemic and meme stock phenomena, investors have struggled to consistently outperform a wider market that has consistently trended upwards. 
In this context, it is unsurprising that active investment managers have turned to new types of data that are external to the investee company and not available from traditional financial sources like Bloomberg. Identifying a new dataset that provides an informational advantage over the rest of the market offers a reliable path to generating alpha, something that is otherwise increasingly difficult to do. Classic examples include satellite imagery, social media posts, credit and debit card transactions and mobile device usage.
But despite its widespread adoption in some asset classes – most notably hedge funds, where a majority of managers use it as a fundamental part of their investment process – alternative data still has significant room for growth. The market was valued at a relatively modest USD1.7 billion globally in 2020 and is projected to expand at an aggressive compound annual growth rate of 58.5 per cent between now and 2028.
Private equity has been widely recognised as the likely next frontier for alternative data. It represents a larger market opportunity than hedge funds, in terms of total assets under management: in its latest annual report, Preqin estimated global private equity and venture capital AUM at USD4.74 trillion, compared with USD3.87 trillion for hedge funds. A much-cited survey from found that only 27 per cent of PE investors currently use alternative data, but another 25 per cent already plan to do so in the future.
Those skeptical of the potential use-cases of alternative data in private equity point towards the same barriers that have delayed its adoption to date. PE firms are long-term investors who back private companies for multi-year periods. An accurate prediction of whether a retailer will report a good or bad quarter based on satellite imagery of their parking lots is much less useful to them than to a hedge fund that can short public companies. Once invested in a company as a majority shareholder with board representation, PE firms can access granular information on investee company performance in real time without needing to seek out external sources of data.
However, there are other scenarios in which the use of alternative data makes just as much sense for PE and VC firms, if not more. The first of these relates to investment screening and selection. The market is phenomenally competitive, with ever-increasing amounts of dry powder chasing the finite pool of private companies (or, in a small minority of cases, undervalued public companies) that are seeking to raise a funding round or suitable for a buyout. Those funds that don’t make use of all available information on a company and the market in which it operates are at risk of adverse selection. They face being left to invest in the companies shunned by their better-informed competitors, after being priced out of the best opportunities that their peers knew how to value properly, by combining traditional P&L data with additional insights.
This dynamic is particularly applicable to funds seeking to identify investment themes and establish a strategic direction. It is increasingly common for VC and even PE funds to specialise in specific niches, such as application software or internet marketplaces, in order to build sector expertise and establish a competitive advantage over more generalist competitors in the eyes of management teams. They also typically invest in riskier, earlier-stage companies with more growth potential than is typically available in public markets. For VC investors, being able to anticipate emerging trends in technology or consumer behaviour is crucial to getting into the next Facebook, Uber or Airbnb on the ground floor. Alternative data that signals a clear direction of travel in terms of technology use or consumer habits is therefore phenomenally valuable.
Alternative data can also add value during the due diligence and investment execution phase. While a PE firm sponsoring a management buyout of a private company in partnership with its management team would typically expect full access to its data room, in the red-hot world of venture capital, some funders aren’t even offered that. Even where they get that access, the information can still be significantly limited compared to that provided by larger public companies. Additional external data that corroborates what the company’s sell-side advisors are reporting is a useful risk mitigation measure.
Finally, and perhaps most importantly, PE investors are distinguished from institutional shareholders in public companies by the concentrated, and often controlling, nature of their shareholdings. With this comes the expectation that PE firms provide hands-on operational support and expertise to their investee companies. The ability to both crunch a company’s proprietary data and glean insights into wider industry trends is crucial to helping a portfolio company increase its market share, improve operational efficiency and ultimately time the exit correctly. Speaking at a conference in London last year, Blackstone’s European head Lionel Assant told of how the firm’s in-house data science capabilities convinced a prospective management team that they were the right sponsor partner.
An effective application of alternative data therefore has the potential to create a virtuous cycle for private equity firms: better investment strategy, selection, execution, management and realisation, in turn driving improved returns and increased LP demand. Yet in a ruthless and highly competitive industry with a laser-like focus on maximising returns, this trend is still only emerging, rather than widely adopted.
As a specialist financial markets and asset management consulting firm whose consultants have private-equity, private-debt and real-estate domain expertise, Lab49 has deployed technology solutions critical for a range of alternative asset managers. Our core services include system selection and implementation support, user experience design, bespoke development, data and analytics, cloud strategy and migration and program management support. Our next article will draw on this experience to examine the technical barriers that exist for PE firms in utilising alternative data and our proposed solutions to these.

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