By David G. Barry
Over the past few months, private equity has been the
proverbial elephant in the room for institutional investors.
With the sector reporting figures that are a quarter behind
the public markets, board members at public pension funds, endowments and
foundations have peppered chief investment officers with questions about how to
view PE’s strong numbers from the quarter ended December 31, especially given
what has transpired economically in 2022 and the publicly disclosed struggles
of SoftBank Vision Fund and Tiger Global, two of the most active
venture investors.
Such questions, say observers, are warranted, especially given that private
equity has been the proverbial gravy train for institutional investors, distributing
a record $1.5 trillion in 2021. In fact, some – such as Massachusetts
Pension Reserve Investment Management (MassPRIM) and The Los Angeles
City Employees’ Retirement System (LACERS) – saw returns greater than 50%
from private equity in 2021.
Such numbers are not expected this summer when public
pension funds begin releasing their June 30 numbers, featuring March 31 private
equity figures. Reality, say industry observers, is about to set in.
“In general, private market valuations lag public market valuations so it is
reasonable for board members to express concerns,” said John Beil, who
joined Partners Capital earlier this year as head of private equity and
real estate. “It’s likely that private equity returns for the quarter ending
June 30 will be negative although less severe than what we’re seeing in the
public markets.”
Bill Bracamontes, a managing director with Wilshire
Associates, concurred, saying the consulting firm expects “private market
valuations to modestly trend downward over the next few quarters with second-quarter
valuations probably being the near-term inflection point.”
Just how impacted institutional investors will be by such a
decline will rest on how heavily they’ve committed to private equity – especially
venture capital.
At an investment committee meeting earlier this month for the Illinois State
Universities Retirement Systems (SURS), Colin Bebee, a managing
principal with Meketa Investment Group, said that some institutional
investors with sizable allocations to private markets actually reported
positive results in the first quarter. Those investors, though, are likely to
see different results going forward, said Bebee.
SURS, on the other hand, had an allocation of 14.6% to non-traditional growth –
which includes private equity – as of March 30. Kim Pollitt, a SURS’
senior investment officer, also speaking at the investment committee, said the
plan is expecting write-downs in the valuations of private equity portfolio
companies. She would not, however, hazard a guess as to how significant they’d
be.
Nicole Musicco, CIO of the California Public
Employees Retirement Systems (CalPERS), told the plan’s investment
committee that private markets are “not immune” to the dynamics hitting the
public markets – inflation, the war in Ukraine – but are “less vulnerable in
the short term.”
CalPERS in November increased its allocation to private
equity to 13% from 8%.
Another member of CalPERS’ team, Sarah Corr, who is managing director of
real assets, said at that same meeting that private markets “may not fall as
quickly as public markets but may not recover as quickly.”
Most expect there to be, in Bracamontes’ words, “meaningful
write-downs in some venture capital and growth equity portfolios given how
frothy those markets have been in recent years and how closely they are tied to
the public markets.” He said he expects some of these managers to try and hang
onto the valuations of last financing rounds but will need to “reset” them once
new – “potentially down” – rounds occur.
Beil of Partners – an outsourced investment firm – said in mid-June that it’s
“impossible to predict the magnitude of impending write-downs,” but that he
expects portfolios “with outsized exposure to publicly traded companies” will
be most impacted. Many firms had companies go public last year – either through
traditional IPOs or through mergers with Special Purpose Acquisition Companies
– but did not exit before the market went south.
According to Statista, 965 companies went public in 2021 –
181 of which were venture-backed.
Beezer Clarkson, a partner with Sapphire Partners, who leads the
firm’s investments in venture funds, said she believes venture investors are
currently taking mark downs if they own publicly traded stock or tokens and
expects “that behavior to continue as long as markets are down.” She also
anticipates that private companies that are valued using public stocks “may be
seeing some additional write-downs in the coming quarters if their comparables
remain down.” It also may “very well be possible” to see potential future down
rounds negatively impact portfolios, Clarkson said.
Beil, who was previously managing director, private equity,
at the University of California, said he expects late-stage private holdings to
be down “anywhere from 0% to 30%, depending on when the company last raised
capital and the valuations of comparable publicly traded companies.
Valuations for late-stage venture deals fell by 4% in the
first quarter, according to CB Insights, but surprisingly continued to rise for
early-stage deals, a phenomenon that investors credited – or blamed – to the
amount of capital available to invest.
Fabrizio Natale, who is an investment director, private equity, with the
Washington State Investment Board, said at an investment committee
meeting that he expects growth equity and venture capital portfolio companies
to have the biggest valuations decline.
WSIB, he said, is “not as exposed” to those segments as some of its peers “who
jumped on the bandwagon.” WSIB, said Natale, tried to be “more constrained.”
As of December 31, it had 22% of its private equity program
in venture capital and growth equity, he said. That, said Natale, is above its
16% target, but he expects the plan to get closer to that figure “as markdowns
ripple through.”
Just how severe the impact could be for late-stage VC/growth equity is
illustrated by Tiger Global, one of the most active venture investors. Its hedge
fund, which invested in tech-focused publicly traded companies, was down 52%
through May, spurring anticipation that Tiger Global’s venture-backed companies
will also be significantly marked down. More disturbing is that SoftBank’s
Vision Funds, which have raised over $100 billon, disclosed a $27 billion loss
– the result of marking down the value of many of its investments.
However, Wilshire does expect that “high-quality and/or
high-growth private assets across investment strategies will continue to demand
premium valuations in this environment, primarily because of the significant
amount of dry powder in the ecosystem,” Bracamontes said.
Industry data tracker Preqin said that as of June 1, the buyout industry had
$873 billion of dry powder – capital to invest in deals – up from $870 billion
at the end of 2021.
Partners’ Beil concurred, saying the impact “will be less severe” for the
buyout market given that firms tend to use a mix of discounted cash flow and
market comps for quarterly valuations. The group that he expects to be most
impacted is the 30% or so who focus on technology. Others, though, who are in
healthcare or industrials, may experience “continued business growth so I
wouldn’t be surprised to see some managers still posting positive returns for
the quarter.”
Aside from lower returns, the drop in values also may lead institutional
investors to shy away from selling stakes in fund holdings in the secondary
market.
Beil said that in the current environment “the discount a secondary buyer will
expect is going to be meaningfully higher than last year.” He said the discount
could be increased even more if the portfolio contains late-stage venture or
publicly traded companies.
“In other words, if an LP needs to raise a liquidity via secondary sales, there
is going to be a price to pay for that in the form of a meaningful discount to
the March 31 NAV,” he said.
A decline in valuations could potentially have at least two positives, say LPs.
One is that it could reduce the amount that many institutions have in private
equity. Numerous public pension funds have reported being over-allocated to the
sector – the result of both private equity’s strong returns and the downturn in
the public markets. Of course, while a decline in PE valuations would “help” in
that regard, public portfolios also are expected to decline as well.
Another potential outcome of a
downturn – at least for LPs – is that the speed by which firms have been
raising funds might slow, said Alison Nankivell, senior vice president,
fund investments and global scaling at BDC Capital and chair of the Institutional
Limited Partners Association.
“A slowdown is a
way to readjust the dialog between GPs and LPs,” Nankivell said. It provides a
means, she added, for a “more balanced conversation.”
Beil, however, did not see any positives coming out of the
downturn.
“While
a sustained downturn may result in more reasonable valuations and a slower
deployment and fundraising pace, the impact on portfolios, including pension
funding rates and endowment payouts, will have material consequences,” he said.
“I wouldn’t go so far to frame it as a positive even if in the long-run it
results in a healthier valuation environment.”