Insights Chart of the Week

Infrastructure SMIDs = Hidden Gems

In addition to the ballooning average fund size we’re seeing, fundraising concentration at the very top end of the spectrum has increased as well. Despite a challenging fundraising environment, the top five largest fundraises captured a staggering 80% of infrastructure capital raised through 2023, as seen in this week’s chart.

What does this mean for investors? The larger concentration of capital being allocated to fewer large-cap funds has led to higher competition for deals with enterprise values over $2.5 billion. As a result, we believe that lower and middle-market opportunities continue to be an attractive segment due to less competition from an increasing number of large and mega-cap funds which all compete for the same deals.   

Learn more in this highlight from our 2024 Real Assets Market Overview.

Infrastructure’s Historical Outperformance? Check!

This week, we’re taking a look at private infrastructure. We continue to see value in manager selection  in this space with top-half strategies adding several hundred basis points of outperformance across vintage years. Like all things in the  private markets, we see tremendous value in  portfolio construction and careful manager selection. Alpha or not, the asset class has outperformed the public markets every single vintage year since 2012, as seen in this chart.

Downside protection, attractive total returns, low volatility and the potential for additional alpha – what more can you ask for? How about inflation protection as well, because, why not? While the results aren’t fully tabulated yet, early indicators suggest that private infrastructure is checking off many of the boxes on this wish list, especially as we navigate the modern era’s first prolonged period of elevated inflation.

Learn more in this highlight from our 2024 Real Assets Market Overview.

Leverage ≠ Higher Risk, Lower Returns

This week we’re taking a look at a spectrum of private equity investments across their leverage multiple at acquisition and their exit IRR. A lot has been debated on the relationship of the two characteristics. We find, with this analysis, there has not been significant correlation between acquisition leverage multiple and performance. The data runs counter to popularly held beliefs that high leverage levels mean increased risk and lower returns.

Sourcing Outsized Returns

This week we’re focusing on interquartile range of funds’ IRR that are bucketed into three implementation strategies across private equity.

The lowest interquartile range in returns is in secondary funds, highlighting its potential for relatively lower risk implied by lower dispersion in returns. More diversification and robust investment selection in co-investment funds are particularly important to be prudent about and are implied by the highest interquartile range vs. primaries or secondaries.

It is important to note that this is not considering the top and bottom deciles of the dispersion. Although the interquartile range for co-investment funds is higher, the top decile could also be higher, implying both higher expected return and risk. Co-investments also typically show a longer tail on the right of their return distribution, emphasizing the potential for strong, outsized returns if investors have capable sourcing, investment selection and risk management skills.

How Long Should You Stay Invested?

Understanding the duration of an investment can be helpful in assessing the illiquidity of closed-end primary funds. In this week’s analysis, we calculate “implied duration” for different private markets strategies. In other words, how much time, on average, is capital at work for a private markets fund?

Infrastructure and credit origination funds demonstrate shorter implied durations – often less than four years. This expedited recuperation period can indicate lower liquidity risk exposures for investors, as capital is returned more swiftly. In contrast, higher risk and returning strategies such as venture capital see an extended duration as their underlying assets take longer to generate and return value.

Understanding the duration of illiquid assets is vital for making proactive portfolio changes that align with an investor’s strategic goals and capital needs. This nuanced approach to portfolio construction is important for LPs seeking to balance their portfolio’s return, risk and liquidity across private market investments.

Does PE Performance Reign Supreme?

In the spirit of our 2024 Market Overview’s theme Hamlet, we beg the question: To invest or not to invest in the S&P 500? To aid Hamlet’s decision, this week's chart highlights the degrees to which average private equity (PE) four-year rolling performance surpasses S&P returns. Regardless of your expectations for interest rates over the next few years, historical performance indicates that private equity has outperformed public markets. In other words, regardless of who was the President, Fed Chair, or winner of the World Series for the past 30 years, private equity performance has historically rewarded investors with lofty premiums. Talk about consistency!

Private equity outperformance is historically most pronounced during periods of mediocre or negative public market returns. This disparity arises more from volatility in public markets than from the nature of private markets themselves. When public markets are strong, PE's outperformance diminishes; in any other environment, it historically increases. This is because PE tends to be conservative in its valuation practices. GPs might avoid inflating expectations and provide a cushion in their valuations when public markets are rising.

We believe that PE performance will continue to outpace public markets due to key factors such as governance and the alignment of investor interests. PE boards are structured to align with management teams, focusing on maximizing business value. Without the pressure of quarterly earnings calls, management can make medium and long-term investments rather than concentrating solely on short-term operations. That’s a tough act for public markets to follow.

Busting Sustainability Myths

This week, we continue with the theme of sustainability. This time, we're showing returns of underlying sustainable deals from the same research as last week. As a reminder, for this analysis we used the UN SDGs for what constitutes a sustainable investment.

What we find is that the return differential is fairly similar across sustainable and non-sustainable deals. This fits with our overall view that sustainable investing will become mainstream and there won’t be a different portfolio set called “sustainable funds.” As investors recognize that sustainable deals do in fact have quite similar return profiles, we believe they will become more common in portfolios over time. There is no evidence that future returns will be reduced by any focus on sustainable investing.

Sustainability Data Challenges Assumptions

This week, we’re switching gears to sustainability. We know...mere mention of the word “sustainability” and we run the risk of moving into an unwinnable debate, but bear with us. Sustainability, as it relates to investment choice, is what we’re focusing on today.

One of the arguments against it relies on the assumption that investments predicated on sustainability are, by definition, lower-returning investments than those that are not. We wanted to test the data ourselves by looking at the difference in addressable market between sustainable and non-sustainable funds. For this analysis, we used the UN SDGs to determine what constitutes a sustainable investment. We then compared the constituent parts of sustainable investments to those of all private equity.

A large proportion, more than one-third, of sustainable fund opportunities are in the venture sphere. That percentage is more than double venture’s overall market share. This is an important takeaway to keep in mind as you build a sustainable portfolio in today’s environment. Additionally, healthcare investments comprise more than half of sustainable assets and triple what that sector represents in the private markets universe. This contrast demonstrates that sustainable investing could require a portfolio construction shift, and that's why data matters.

Look out for next week’s chart of the week when we expand this research comparing sustainable and non-sustainable return dispersions.

The Buyout Exit Advantage

Over the last 18 months, critics of buyout deal performance have often claimed that GPs must inevitably exit their holdings at a loss to prior valuations. The lofty valuations from the last several years should surely have to be sold below the purchase price!

From Q2 2021 – Q2 2023, we observed the “peak” valuations window, seen in 2021 through the market volatility of 2022 - 2023, for realized buyout deals. The data shows that, during this timeframe, on average, deals were exited at a premium to their holding value, relative to their previous valuations.

Re-running this analysis across different time periods over the last several years, the trends have remained consistent. We believe this suggests that GPs are perhaps more conservative in their valuations than what critics suggest. If public markets are going up, GPs may try to avoid false expectations and provide more cushion in what they are presenting as valuations. This healthy conservatism can also extend into turbulent periods as seen in the last two years where buyout deals continued to be exited at premiums. Can your public equities say the same?

The Primary Functionality of Secondary Funds

Private equity has contributed to portfolios seeking long-term gains from its historical strong, multi-decade performance. While private equity offers investors access to potential outperformance (relative to listed assets), it can also entail higher illiquidity.

A closed-end private equity fund’s investment period may last a few years and underlying assets may be held for five years or more. During this period, investors are likely to see limited distributions, as measured by the distributions to paid-in capital ratio (DPI). As portfolio companies in the fund generate value and are sold at a profit, DPI begins to accelerate, though it takes the average buyout fund over eight years to distribute its cost basis. Venture funds may take even longer. We believe secondary funds can offer valuable mitigants to these effects by presenting investors with immediate diversification and enhanced liquidity opportunities.

Secondary buyers step in as replacement investors by purchasing the commitment to a fund from the original investor. This provides immediate access to an established, mature portfolio and can facilitate faster distribution of cash flows to investors on a DPI basis.

As a part of thoughtful portfolio construction, LPs should weigh the potential for secondary funds' liquidity advantages, risk mitigation features, and diversification benefits across vintage years, industries, geographies, and GPs, alongside pricing advantages.

Return of the Levered Buyout?

This is an argument we hear often. Today, it is based on the premise that higher rates, coupled with the higher leverage levels being taken, means buyout returns will suffer drastically. Yes, there has been an upward trend in acquisition leverage multiples, but we haven’t moved a lot over a longer timeframe like the last 15 years. Our data shows median net debt / EBITDA is around the 5.0x mark right now. So yes, there is leverage – but is it so excessive that it can hinder return outcomes altogether?

This week, we look at returns of realized buyout deals by leverage and deal year groupings.

No, your eyes don’t deceive you; there is indeed a significantly lower dispersion of returns for highly levered deals across all cycles. Fascinating. Returns don’t appear to be consistently better for one level of leverage versus another. Sure, pre-GFC, high leverage levels hurt returns, but is that an environment we believe will return?

Interestingly, while lower leverage produced better returns, it was not so much better that you can conclude that high leverage in itself means returns will suffer. 

PE Efficiency Outperforms PMEs

This week’s chart is for those still struggling to recover from their 2022 hangover and singing the “valuations are inaccurate” song. Throughout 2022 and early 2023, it was broadly decided that private equity couldn’t be flat, let alone up, when public markets were down. It had to be a valuation gimmick that would correct at some point. That hasn’t happened, especially since public markets have seemingly moved up, but some investors hold steadfast to their belief that day of valuation reckoning is near. But private equity has historically outperformed in severe public market downturns. Our focus is on answering the question why private equity has historically excelled. The outperformance in 2022, along with the continued performance in 2023, is a simple matter of stronger revenue and EBITDA than the profiles of public companies typically found in comparison benchmarks such as the S&P 500 Index.

Does this mean private equity investors are smarter than their public counterparts? Not necessarily, but the industry’s governance does prove to be better, and the choice of companies is different and has historically contributed to better performance. Buyout has generally avoided some areas that are more represented in broad public market indices, notably materials and consumers. Instead, it has generally been overweight in sectors that have shown greater growth and resilience during economic cycles, such as information technology and industrials. More importantly, the size of companies varies drastically, with an average company size of $32.5B in the S&P 500 Index vs. $328M in the buyout universe.* The amount of control you can exert over such companies is likely enormous vs. larger ones.

Buyout’s operational outperformance is closely tied to better sector and company selection and a greater ability to create paths for operational growth. We believe this is, in the end, the core of the reason private markets have historically outperformed.

*Source: Hamilton Lane Data, Bloomberg (December 2023)

Infrastructure as Portfolio Ballast

Following the GFC, conventional wisdom held that in volatile market environments, private infrastructure provided a hedge to portfolios due to their steady cash flows, ability to pass on cost increases, and lower correlation to public markets. This thesis had yet to be tested in a raising rate and/or high inflationary environment for private infrastructure – both of which we have witnessed globally for the past two years.

Looking across a combination of time periods that encompass different levels of market volatility, asset class performance and CPI rate changes, we observe a strong, positive, statistically significant correlation between one-year rolling private infrastructure performance and changes in CPI in the early GFC period, and subsequent volatility and rising rate environment of ’21-’23 and ’22-’23, respectively.

This is a welcome sign that the investment thesis for infrastructure has played out as expected under these market conditions. We believe that CPI plus basis point premium remains a reasonable option when private infrastructure is used as an inflation hedge within a portfolio while also providing defensive qualities in volatile market conditions. While the jury is still out on the long-term correlations between CPI and infrastructure, it seems the asset class can play its desired role during periods of rapidly escalating inflation.

Consider this…

When constructing a portfolio, investors must be mindful of developing risk and return assumptions that encompass data across historical periods. The evaluation of strategies in relevant time periods and the application of forward-looking investments can help guide judgement on portfolio construction and performance expectations.

Vintages since 2010 feature a higher proportion of unrealized gains, emphasizing the importance of assessing fund age and its potential impact on an overall portfolio. These differences across strategies and vintages underscore the significant spread between top and bottom-performing managers, which present both opportunities and risks for investors.

Across asset classes, spreads have consistently remained wide over industry history, suggesting that despite the growth of the industry, equity markets have not become more efficient by this measure. Certain strategies can exhibit a greater dispersion of returns across market cycles, offering substantial long-term return potential. This draws attention to the intricacies of portfolio management and underscores the critical role of thorough analysis and forward-looking decision-making to meet investment needs.

What Condition Are Your Positions In?

In this week’s chart, we look at the proportion of deals in the buyout asset class that were either held below cost or at a write-off throughout the last 20 years.

We found the average loss ratio (the number of deals held below cost or at a write-off over the total number of deals in the given year) over the 20-year time period to be 22% on a deal level. However, this loss ratio can vary greatly from regional exposures, sectors, vintages and whether investments occur on a deal level, or fund or fund-of-fund level.

Manager skill, economic conditions during acquisition, exits and exit opportunities can significantly impact the performance of buyout deals.

So, should investors just count their losses? While recent periods have seen lower-than-average total loss ratios, it’s important for investors to reduce the idiosyncratic risk that individual deals could have by diversifying across a number of deals, regions, sectors, vintages and managers.

Definitions
Corporate Finance/Buyout - Any PM fund that generally takes control position by buying a company. 

Why Do You Build Me Up?

Buyout has experienced tremendous growth over the years, especially since the turn of the new decade. This week, we compare the growth of all buyout funds to the portion of such funds that managers have deployed but are still waiting to distribute back to investors. We define the latter sample of funds as those with >70% deployed but with DPI <0.1x. A low DPI suggests that the investments made by the fund have not yet been realized.  

Buyout, like many other private market asset classes, has seen growing demand from investors with record fundraising figures in 2021. Fundraising since then has been more challenging, albeit still far above long-term averages. Deal activity around this time also hit a record amount which meant increasing many funds’ deployment speeds into private markets. This has also since been challenged with quickly changing market conditions. Adding to this, exit activities have been sluggish: Holding periods have increased, IPO markets have remained muted and M&A markets have slowed. All of these factors reduced the pace at which capital was distributed back to investors. This drives the build-up in the share of NAV occupied by “fully invested but unrealized” funds. 

However, it is also important to note that recent years’ deal activities will take time to realize and distribute back; the investment time horizon in this asset class spans across multiple years and requires patient capital. That patience may pay off with record distributions (in absolute terms) if deal activity thaws in 2024.  So, it is most important for investors to stay diversified across managers, vintages and sub-strategies to reduce volatility and maximize the potential to reach target returns.   

$1 for Your Thoughts

Adding private markets to a portfolio can bring diversification benefits, improve risk-adjusted performance and provide access to a greater investable universe compared to public capital markets. Using a "60/40" stock-bond portfolio as a benchmark, we track the growth of $1 of a mature, diversified private markets portfolio and a “traditional” portfolio with a 45% private markets allocation from 1Q’2013 to 2Q’2023. The private markets allocation encompasses a diversified mix of private markets strategies, inclusive of private equity, private credit and private real assets.

The outcome underscores the potential of a private markets-enhanced portfolio to generate superior returns across diverse macroeconomic landscapes. Notably, the 45% private markets-allocated public portfolio has yielded a remarkable 143% cumulative return since inception, surpassing the 78% yield of the 60/40 public portfolio. This is a staggering wealth creation gap for investors who are able to maintain a substantial private markets exposure.