Outlook Private Equity
Disclaimer: The information and materials prepared are for internal use only and on how the Dancap Family Investment Office (“Dancap”) views current market dynamics. Dancap does not guarantee the accuracy or completeness of the material and it is not intended in any manner to be investment, financial, legal, accounting, tax or other advice and should not be relied upon.
Dancap's Current Private Equity Strategy
May, 2023
Dancap has over 30 years of track record investing in private equity through third party funds, co-investments, and direct investments. Our private equity portfolio is diversified across several underlying strategies and geographies, but our key focus is US buyout, secondaries and to a smaller extent, growth equity funds . This market overview provides an update on current market dynamics, outlook, and future risks within as they relate to Dancap’s current private equity holdings.
Buyout
Strategy
During periods of economic stress, private equity buyout funds have historically generated higher returns than other vintages. As shown in the chart on the left, the best performing buyout vintage funds immediately followed economic recessions (2000 and 2008). In 2001, the median buyout fund generated a net 25% IRR, significantly outperforming 2000 vintage funds that returned a median IRR of 10%. Similarly, in 2009, the median buyout fund generated a net 22% IRR, compared to 8% for 2008 vintage funds. These figures suggest that private equity buyout funds have historically been a good investment option during times of economic stress.
When public markets are extremely volatile (such as 2000, 2007, 2011, and 2020), private equity funds can significantly outperform their public peers, as shown in the chart below to the right. This is because private equity funds typically have a long-term investment horizon, which allows them to weather short-term market volatility and focus on maximizing returns over a longer time period. As a result, private equity can be an attractive option for investors who are seeking greater stability and higher compounded returns in their portfolios
sources: (LHS) Bain & Company Global Private Equity Report 2023. (RHS) BlackRock Alternatives; 2023 Private Markets Outlook – A new era for Investors
Since 2009, private equity managers have enjoyed strong returns in their funds, thanks to low interest rates and expanding multiples. However, with inflation near a 40-year high and interest rates on the rise, most managers find themselves in uncharted territory, as shown in the chart below. These economic factors create a challenging environment for private equity managers, who must navigate shifting market conditions while seeking to generate attractive returns for their investors.
source: Bain & Company Global Private Equity Report 2023
During uncertain times like these, it’s especially important for investors to partner with private equity managers who have successfully navigated previous market cycles. By partnering with experienced managers who have a deep and proven track record, investors can maximize their chances of success and capitalize on market dislocations as they arise. These managers have a wealth of knowledge and experience to draw upon, allowing them to adapt to changing market conditions and make informed investment decisions that can help to generate attractive returns even in challenging environments.
Outlook
According to Jefferies, limited partners are experiencing negative net cash flows in their private equity portfolios for the first time in several years, as capital calls outpace distributions. Higher interest rates and a slowdown in bank lending have led to declines in overall deal volume and valuations, resulting in this turnaround in cash flows. According to Bloomberg Law, M&A deal volume was down 46% YoY in 2022. Given today’s economic and political uncertainty, the overall decline in new deals and lack of exits could persist, creating a knock-on effect for future fund-raising and overall liquidity in the asset class. Some sponsors are still finding ways to complete transactions, but with much higher equity contributions, as seen in the joint acquisition of Qualtrics by Silver Lake and CPP for $12.5B, which included $11.5B of equity and $1B of debt. However, these deals structures could come at the expense of higher returns.
Secondaries
Strategy
Secondaries funds can be an attractive source of returns during periods of economic stress. According to Preqin, the median secondaries fund launched in 2008, 2009, and 2011 outperformed all other private equity strategies in the same vintage by roughly 2% per annum. Part of the reason for this outperformance can be attributed to the “denominator effect” whereby during market corrections, institutional investors who are mandated to maintain minimum allocations to public equities are forced to sell down their private equity portfolios (at distressed prices) and use the proceeds to rebalance their public equity holdings.
According to Jefferies, 50% of secondaries sales volume in 2022 was comprised of first-time limited partner sellers who were overallocated to private equity, with many of these being private pensions proactively seeking liquidity to rebalance their portfolios and help fund defined benefit programs in a slowing distribution environment. Median pricing for secondaries across all strategies in 2022 was 81% of NAV (fair market value), or at a 19% discount, compared to 2021 pricing levels of 92% of NAV . Real estate secondaries and venture secondaries traded below median pricing at 71% and 68% of NAV in 2022, down from 79% and 88% in 2021, respectively, due to their greater sensitivity to changes in interest rates.
Sources: (LHS) Preqin Private Equity Secondaries Launched into Financial Market Stress Tend to Outperform https://www.preqin.com/insights/research/blogs/private-equity-secondaries-launched-into-financial-market-stress-tend-to-outperform
(RHS) Jeffires Global Secondary Market Review https://www.jefferies.com/CMSFiles/Jefferies.com/files/IBBlast/Jefferies-Global_Secondary_Market_Review-January_2023.pdf
Outlook
The secondaries market has become an increasingly important part of the private equity industry in recent years, and it is expected to remain robust in 2023. This is largely due to the fact that limited partners are seeking liquidity to rebalance their portfolios, especially in the current economic climate. With uncertainty around interest rates, inflation, and the pandemic, investors are looking for ways to manage risk and ensure that their portfolios are properly diversified. Additionally, financial sponsors are facing challenges in exiting their investments through traditional sales and IPOs. This is partly due to the market volatility and uncertainty, but also due to the fact that many companies may not meet the necessary criteria for these types of exits. As a result, secondary sales may be a more attractive option for these sponsors to generate liquidity and exit their investments.
Overall, the secondaries market is expected to remain strong in 2023 as both limited partners and financial sponsors seek to navigate the challenges and uncertainties of the current economic environment. This presents an opportunity for investors who are looking for attractive returns and exposure to the private equity asset class, as well as for secondary managers who are able to identify and execute on promising investment opportunities in the market.
Growth Equity
Strategy
The growth equity market has been facing a challenging environment. Higher interest rates and increasing economic uncertainty have lead to lower valuations by as much as 30% on average in later stage growth companies (see chart below to the left). This has resulted in a holding pattern as both buyers and sellers are hesitant to transact. Recent challenges have also been exacerbated by investor recalibration as much of the technology’s momentum from 2021 and early 2022 (stemming from the pandemic effect) has moderated. That said, some industry experts are optimistic that the market will recover over time and that the current downturn may present an opportunity for growth equity firms to identify undervalued companies struggling to raise money and invest in them for the long-term (see chart below to the right). As the economy gradually recovers and market conditions improve (and assuming interest rates come down), these companies may be able to grow into their earlier valuations, providing attractive returns for growth equity investors.
Source: State of the Market; StepStone Group Inc. 2023 Venture Capital Annual Meeting
Outlook
The Initial Public Offering (IPO) and Merger & Acquisition (M&A) markets have experienced a near-complete shutdown since 2022. This has caused a significant slowdown in exits within the growth equity sector, as companies are finding it difficult to go public or be acquired by larger firms. Simultaneously, growth equity managers are facing challenges in deploying new capital due to the uncertainty of current market conditions. Without clarity on interest rate trends (driven by inflation), as well as uncertainty about the potential for an economic recession, investors are hesitant to commit to new deals. It is unlikely that deal activity and exit activity will recover until there is greater certainty in the markets. Until then, growth equity firms will need to focus on managing their existing portfolios and optimizing their current investments.
Dancap continues to look to invest with managers who have demonstrated strong positive returns and consistent performance in their specific areas of expertise across market cycles.
To see the Dancap Private Equity Investment Criteria and Portfolio, please click here.