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Widening the deal aperture in private markets

BlackRock Alternative Specialists’ David Lomas discusses how its three-pronged approach to deal sourcing makes it well positioned to support private market investors heading into 2021.

Patience will be a virtue for investors as they seek to increase their exposure to private markets heading into 2021. Performance dispersion within private equity and private credit is likely to be accentuated as the long-term impact of Covid-19 is felt; even within Covid-robust sectors such as Healthcare and Technology, there will be plenty of winners and losers.

And with record levels of dry powder waiting to be deployed in the PE space, investors are going to need to ensure they are backing the right managers; i.e. those with a unique ability to source deals better than their peers.

David Lomas is Global Head of BlackRock Alternative Specialists (BAS), a client-facing sales team that collaborates with investment groups across BlackRock Alternative Investors (BAI), a USD263 billion platform delivering a range of investment solutions across private equity, credit, real estate, infrastructure and hedge funds. Specifically, the BAS division works with clients to help them in their portfolio construction across alternatives.

Commenting on the dry powder volume (which stood at an estimated USD2.5 trillion at end of 2019 according to Bain & Co), Lomas is keen to point out that globally, the private equity market is still only approximately 5 per cent of the size of public equities, but notes that companies today are choosing to stay private for longer.

“If you think about the average time of getting to the IPO stage, it is now in the 10 to 11-year range, compared to three to six years pre-GFC. Between 1990 and 2001, the average time to IPO was 4.6 years, while from 2002 to 2018 it had grown to 6.4 years. If you look at the growth in public companies in the US, it has fallen by about 40 per cent since 1988 while private companies have grown 20 per cent.

“The big question now is how do you source those opportunities? If you can’t find and access the deals, that’s a challenge. That ability to get access to companies and to build in protections around the investments being made will be mission critical for investors,” says Lomas.

Large managers continue to grow but there if smaller and mid-market managers can really demonstrate a robust, proprietary sourcing model, they will have a chance to attract investor interest. The only problem is that due diligence has been a challenge for some investors this year, who have stuck to investing with managers they already know, as opposed to doing ODD on managers they’ve never met.

“Middle-market funds have a wide aperture to go and chase deal flow and fish for deals in a different pond to the large-cap and mega-cap funds,” adds Lomas.

Widening the deal aperture

With deal sourcing a key consideration for next year, Lomas explains that there are three ways BlackRock sources transactions.

One is through portfolio teams who are invested in corporates or real asset projects and already extensive networks in place. The second is via BlackRock’s capital markets team, which has two versions: one looks at public markets, prosecuting deals equivalent to USD150 billion in liquid credit per year, for example.

“The other is the equivalent team we set up two years ago to look at the private market and today we probably review over 260 deals a month,” explains Lomas. “Critically, we assess all deals and think about the syndication of those deals across the platform. It helps the borrower think about their longer-term relationship with us, making us an interesting partner for them longer term. This is because we have different pools of capital we manage on behalf of our investors that create future flexibility for them, making us much more efficient as a capital markets partner.”

Having those three mechanisms widens the aperture for BlackRock to look at deal flow. Lomas says they feel pretty optimistic “about our ability to source deals, so the amount of private market dry powder is less of an issue for our business”.

In respect to BlackRock’s direct lending business, the onus is on originating loans in the capital structure with very high levels of covenant protection, to protect its clients’ interests. The rise of ‘covenant-lite’ deals in recent times is a symptom of too much capital chasing too few deals, with managers willing to make concessions to get deals over the line.

Lomas warns: “As an investor, don’t chase the highest return. Think about the architecture of that return; what is the governance around a company? What is the market opportunity and the manager’s ability to source the right transactions? And how do you build the optimal portfolio that provides the return and resilience required?

“If you can be successful at selecting the right companies in the right sectors, the potential returns on offer for direct lending strategies are going to be more exciting to investors and we think there is a huge opportunity in private credit. With rates likely to stay lower for longer, that premium one gets on the illiquidity is going to continue to be attractive to investors who might have funding gaps and/or liabilities to meet.”

ESG…practice what you preach

As institutional investors evaluate their private market portfolios, they are focusing more and more of their due diligence process on ESG metrics to discern how GPs think about ESG risks as part of their ongoing portfolio management activities. Investors want performance, but they want it in a way that is sustainable and which has a positive impact on the planet.

Thematically, this is going to remain a central tenet of investor demand for all private market fund groups to be aware of. The Task Force on Climate-related Financial Disclosures (TCFD) is certainly helping to drive adoption of ESG reporting among corporates, both in public and private markets. Moreover, the central banks in Europe are adding green bonds to their asset purchasing programmes, which is further driving engagement at the borrower level.

As a triumvirate, the regulators, the central banks and the investors are all driving this ESG trend.

At BlackRock, Lomas confirms that ESG risks are already a central component of portfolio risk management.

“We made a public commitment to ensure all our active strategies were fully integrated to ESG,” he says. “Our view is that ESG-integrated portfolios provide better risk-adjusted returns to our clients. Each investment strategy on our platform has its own ESG policy. We’ve developed a comprehensive ESG toolkit, including detailed due diligence questionnaires that underpin our own ODD. We have senior leaders across each of our alternatives’ disciplines responsible for the ESG agenda and to ensure it is part of the investment approval process. They sit alongside our dedicated sustainable investing team, so there is a double layer of governance in place.”

There is, says Lomas, a significant focus on ESG data collection when making any investments on the platform, which form a part of the investment management agreement (IMA) “so we can monitor and track the ESG performance of our underlying investments on an ongoing basis”.

“For renewable power investing, for example, we can quote the carbon offset that comes from every dollar invested, and which of the UN Sustainable Development Goals the strategy is aligned with and reported on. We want to understand the journey a particular company is on and be able to monitor and measure different ESG criteria over time. Then you can act accordingly if you feel things are not moving in the right direction,” remarks Lomas.

Speaking to David Rubenstein recently, BlackRock Chairman and CEO, Larry Fink said that the firm was asking more of the companies it invests with to report on SASB and TCFD, which BlackRock itself is doing and providing more transparency on.

“Our rankings within SASB are quite high but we’re not perfect. We are working on our diversity metrics. Our compensation metrics are strong across the board. But where we were weak was not placing some of our women into the highest paid jobs. Now we are evolving that and moving them to the portfolio management teams. We are navigating BlackRock to do what we are asking other firms to do. We are as focused on these issues as any company,” Fink told Rubenstein.

Going back to the earlier point about the volume of dry powder sitting in private equity, Lomas is confident that as we head into 2021, the opportunity to create income through the private markets is only going to continue to grow, as the ability for companies to access traditional sources of lending diminish.

Private markets will, he says, be a source of financing to help companies to get through the rebound of the economy, “as many are going to short on cashflow for a while, regardless of a vaccine”.

“Broadly speaking, the number of companies impacted by Covid is going to create major opportunities for private capital. I see huge potential across the private markets universe. Private credit right now is a very interesting space but we also see multiple opportunities in VC and the private equity buyout space.

“We feel pretty confident about what’s ahead of us,” Lomas concludes.

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