After ten years of dynamic growth, private markets settle in for the next decade.
Welcome to the 2020 edition of Aura’s annual review of private investing. Our ongoing research on the industry’s dynamics and performance has revealed several critical insights, including the following trends.
Private markets complete an impressive decade of growth. Private market assets under management (AUM) grew by 10 percent in 2019, and $4 trillion in the past decade, an increase of 170 percent (Exhibit 1), while the number of active private equity (PE) firms has more than doubled and the number of US sponsor-backed companies has increased by 60 percent. Over that same period, global public market AUM has grown by roughly 100 percent, while the number of US publicly traded companies has stayed roughly flat (but is down nearly 40 percent since 2000).
The fundraising outlook remains favorable. The early prognosis for 2020 is for continued strength: by the end of 2019, large firms had announced targets collectively approaching $350 billion, more than at year-end 2018. Further, limited partners (LPs) continue to raise their target allocations to private markets. Even at current levels, LPs appear to be under-allocated versus target levels by more than $500 billion in PE alone—as much as the global amount raised for PE in 2019.
Industry performance has been strong, but manager selection remains paramount. PE outperformed its public market equivalents (PME) by most measures over the past decade. Variability in performance remains substantial, however (Exhibit 2). So, the challenge—and the potential—of manager selection remains paramount for institutional investors. Although persistency of outperformance by PE firms has declined over time, making it harder to predict winners consistently, new academic research suggests that greater persistency may be found at the level of individual deal partners. In buyouts, the deal decision maker is about four times as predictive as the PE firm in explaining differences in performance. This finding is intuitive to many in the industry but remains tough for many LPs to act on.
The more things change.... The shape of the industry has evolved as it has grown: buyout’s share of PE AUM dropped by a third in the past decade, while venture capital (VC) and growth have taken off, led by Asian funds. Today, Asia accounts for more than twice as much growth capital as North America does, and about the same amount of VC.
... the more they stay the same. Megafunds of $5 billion or more increasingly dominate buyout fundraising, making up more than half of the total in 2019. The share of funds below $1 billion has fallen to a 15-year low. Yet paradoxically there is little evidence of any consolidation at the top of the industry. And even as the number of active PE firms continues to grow (it’s now nearly 7,000), more managers are calling it quits than ever. Most of those raised just one fund, suggesting that attrition is mainly a result of one-and-done managers.
Technology in every sector. Deal volume declined in every region except North America, where the amount of capital invested rose 7 percent to $837 billion, a new high. Tech deals, up almost 40 percent, powered this growth. In parallel, the number of tech-focused private market firms has grown rapidly, while many others have tilted in that direction. Increasingly, we see general partners (GPs) that once had a technology “vertical” team now starting to view technology as a horizontal theme cutting across many of their deals.
Signs of a peak? US buyout multiples climbed yet again in 2019, continuing a decade-long trend, to reach nearly 12x. Leverage surpassed levels last seen in 2007. Dry powder rose further due to record fundraising and stagnant deal volume. It now stands at a record $2.3 trillion (Exhibit 3). PE accounts for most of this total, though PE dry powder is still less than two “turns” of annual deal volume, within the range of historical norms.
The industry finds new opportunities in ESG. Public interest and LP pressure to take environmental, social, and governance (ESG) factors into account in investing have soared, prompting greater transparency on ESG policies and performance as well as a rise in dedicated “impact funds.” Nine of the ten largest GPs now publish annual sustainability reports. Perhaps more significant, our survey data show a clear uptick in the value that managers attribute to ESG—in other words, they increasingly find that these factors are positive (or neutral at worst) in achieving strong performance. Still, the private markets are only in the early stages of materially incorporating ESG factors into investment and portfolio management processes.
Diversity remains a challenge. Private market firms have made only limited progress in improving diversity and inclusion. Women represent just 20 percent of employees across the private markets and less than 10 percent in investment team leadership positions. The industry’s performance on other forms of diversity is also poor—recent Aura survey data places combined black and Hispanic/Latino PE representation at just 13 percent for entry-level positions and less than 5 percent for senior roles. Private markets firms may be missing an opportunity: increasing evidence shows that greater representation may meaningfully enhance performance.
Many firms are thinking about how to digitize the investment process—and a handful are moving ahead. The largest GPs have taken the lead, especially in sectors such as real estate where investors can draw upon larger, more accurate data sets. In these areas, machine-learning algorithms using a combination of traditional and nontraditional data have demonstrated the ability to estimate target variables (such as rents) with accuracies that can exceed 90 percent.
Many firms have predicted a downturn, but fairly few have adapted their operating model to prepare. New Aura research shows that while most fund managers consider cyclical risk as part of their due diligence and portfolio management processes, only a third have adjusted their portfolio strategy to prepare for a potential recession. GPs can take several steps to build resiliency and improve performance through a downturn. One example: GPs with dedicated value creation teams outperformed those without them by an average of five percentage points during the latest recession.
Aura’s annual review reveals an expanding and developing industry.
Private markets stayed strong in 2018. True, fundraising was down 11 percent. But $778 billion of new capital flowed in. Investors have a new motivation to allocate to private markets: exposure. More investors believe that private markets have become effectively required for diversified participation in global growth. Global private equity (PE) net asset value grew by 18 percent in 2018; this century, it has grown by 7.5 times, twice as fast as public-market capitalization (Exhibit 1). Private markets, including PE, debt, infrastructure, real estate, and natural resources, have graduated from the fringes of the economy to the mainstream.
More tools for investors and managers
With growth comes maturity. In 2018, private markets added more flexibility, depth, and sophistication. As our report examines in detail, secondaries have scaled rapidly and made the asset class easier to access and to exit.
These funds are injecting liquidity and creativity into the marketplace, helping limited partners (LPs) shift strategies and manager lineups more quickly, and more than ever, helping general partners (GPs) restructure and extend legacy funds.
They also offer increasing flexibility for investors to diversify and manage portfolio-construction risk, including through the use of options on investment stage, geography, industry sector, and fund manager.
Another structure gaining prominence, capital-call lines of credit have (along with other factors) compressed the J-curve (Exhibit 2), while drawing a watchful eye from some LPs. Our research finds that median funds in vintages 2012 to 2015 broke even in their second year, rather than in the third, fourth, or fifth year typical of most prior vintages.
Co-investment is a third structure adding depth to private markets. It has shaken off concerns about adverse selection to become an effectively standard dimension of pricing. In some cases, LPs have sought to partner with their GPs and secondaries fund sponsors to restructure and extend funds, a growing strategy as crisis-era funds reach the end of the road yet still have meaningful value-creation potential.
A few large institutions have even developed strategies focused on sourcing direct transactions from their GPs’ portfolios. Done well, they can find quasi-proprietary deals in which to deploy large sums of capital while enabling GPs to eat their cake and have it too by recognizing gains while maintaining some degree of upside over time.
Inspired, many other LPs are voicing similar intentions. But a supply challenge looms: demand for PE co-investment vastly outstrips the opportunities provided by GPs. Even when LPs successfully build a small portfolio of direct investments, they may be running more risk than they think.
One or two impairments can adversely affect the asset-class portfolio, with knock-on effects on employee compensation and even the institution’s long-term health. Very few direct investments have been exposed to a broad-based downturn. When one comes, the way that LPs and their governing boards react to impaired positions will bear watching.
New management techniques
Collectively, these developments have helped the industry broaden its appeal to LPs without abandoning its underlying structures. And the industry’s conduct has changed with its context. Savvy GPs have expanded their firms’ abilities to take advantage of today’s most prominent sources of value creation. Aura research shows that the 25 largest GPs all have operating teams, and most plan to expand them. Leading firms have also pioneered several digital techniques to wrest greater efficiencies in operations, deal sourcing, due diligence, and other core activities.
Several recent examples are detailed in our report. A European venture-capital (VC) firm has built a machine-learning model to analyze a database of over 400 characteristics of more than 30,000 deals, identifying about 20 drivers of success for various deal profiles. These often turn out to be unusual combinations of characteristics that no one would otherwise have suspected had much bearing on performance.
A PE firm conducting a due diligence wanted to validate its revenue forecast for a banking product. It used natural-language processing to analyze the public-complaints database published by the US Consumer Financial Protection Bureau. The tool found a spike in customer complaints about a similar product at a rival bank, and the firm discounted its revenue projection accordingly. Another adviser has gone a step further and digitized several of its due-diligence processes. It uses web-scraping tools to monitor changes in market sentiment for its retail clients. Geospatial analyses help it evaluate the strength of its footprint. HR analytics help it evaluate management’s capabilities.
These are all noteworthy advances. Yet pressure continues to build in the system. Deal multiples have continued to rise—to 11.1 times, from 10.4 times in 2017—spurred in part by record levels of dry powder, at $2.1 trillion. Deal value hit a record, but the number of deals remained relatively flat for the fourth consecutive year. (Note, however, that as a multiple of annual equity investments over the prior three years, dry-powder stocks have crept noticeably higher, growing 22 percent since 2016. If growth in dry powder continues to outstrip deal volume in a strong market, this may provide a tailwind for multiples. But if the market slows (say, if multiples contract or deal activity slows), then this sizable war chest may contribute at least for a period to downward pressure on fundraising.)