What endowments and foundations should know about investing in private assets

In the Q&A below, StepStone partner and portfolio manager Michael Elio and Fidelity institutional portfolio manager Ian Johnson discuss the state of private markets today, including the impact of manager selection in venture, how to navigate complexities of the asset class, current valuations, and the emergence of secondary private markets.

Ian Johnson: The 2023 NACUBO-Commonfund Study of Endowments¹ (NCSE) shows that the largest endowments continue to have significant allocations to private assets, but those organizations had some of the lowest returns among their peer group in 2023. What were the causes of this underperformance?

Michael Elio: Performance last year was a continuation of the valuation reset in private assets — more specifically for those invested in venture capital. Many endowments have outsized exposure to venture capital in their privates' portfolios and it continued to drag on returns into 2023. Outperformance in private equity is predicated on a strong selection process, and the more successful E&Fs tended to have more disciplined and thoughtful managers, along with better selection of deals. Those with significant exposure to buyout had a better experience; buyout valuations bottomed out in Q3 2022 and continue a steady positive return throughout 2023 and into 2024.

Johnson: Dry powder² has reached unprecedented levels. Is this a sign that there is too much capital for too few opportunities? Where are the most attractive opportunities today, and what gives you pause for concern?

Elio: Though dry powder in private equity globally has reached record levels alongside low investment activity, that does not tell the entire story. Dry powder as a percentage of a fund's net asset value (NAV) remains at modest levels and it is more concentrated at the larger end of the market. We believe there are pockets of opportunities for small and midsized funds (with assets between $7 billion and $10 billion). Dry powder has not grown as much in this space, so selection has remained more disciplined. As private equity activity steps up and distributions are reinvested back into managers, we will likely see more modest growth in dry powder. In Q4 2023 we saw early signs of a pickup in capital markets activity. Venture capital, on the other hand, has suffered significant declines in fundraising and that is expected to continue into 2024.

Johnson: With so much capital at play, can you comment on current valuations? How do they compare to valuations, historically? Do current valuations suggest it is a good time to invest in private assets?

Elio: Valuations are always the concern. It is why the private equity model rewards managers AFTER the company is sold. As a research focused organization, we monitor trends and valuations that are on top of the list. Historically, private equity sponsors have exited companies at or above the prior period mark, historically at about 10%. It is a much more disciplined valuation environment today and more consistent risk-free rates will be supportive; with the recent readjustment in valuations, the few exits recorded have been closer to reported NAV but indicate fair value.

The exhibits below [see Exhibit 1 and Exhibit 2] highlight the decline in valuations across industries and buyout sizes. Based on this, we believe it's a good time to invest in private markets. The fragmented base of companies in the U.S. is moving from entrepreneurial/family hands to institutional, and those institutions tend to be investors in private markets. Flight to quality towards defensive, secular growth sectors such as healthcare has driven recent deal flows and relatively raised valuation multiples. More cyclical sectors, such as industrials and consumers, have seen deal flows decline in recent years. Valuation corrections in transactions in those sectors were a primary driver of the modest drop in overall purchase price multiples.

Deal flows in small market segments started to increase in 2023, reversing a trend that had seen large and global market segments attract much of the flows. Given their greater reliance on debt capital markets, medium, large, and global market segments have seen EBITDA valuations correct an estimated 1.0-1.5 times, which drove the downward trend in overall purchase price multiples last year.

Exhibit 1 and Exhibit 2
EBITDA* valuations have been on a declining trend in recent years.

Source: StepStone Portfolio Analytics & Reporting as of September 30, 2023; SPAR data is updated continuously; values are subject to change. SPI Reporting is StepStone's proprietary portfolio monitoring dashboard. Market capture measures the relative performance of an investment manager or managers relative to an index.
*EBITDA: Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a measure of core corporate profitability.

Johnson: Can you share your expectations for capital markets in 2024? If the initial public offerings (IPO) and mergers & acquisitions (M&A) markets remain subdued, how can private equity firms exit their investments and/or distribute capital back to Limited Partners this year?

Elio: The slowdown in M&A and IPO activity since 2022 has resulted in very challenging distribution activity in private equity. Contributions were also down and there are several reasons for this:

• 1. Instability in the credit markets and a lack of support for M&A. This has improved since the start of 2024.
• 2. Seller/buyer price gaps, which have been large, will take time to narrow.
• 3. The IPO markets were closed, especially for larger funds that leaned more on capital markets to exit their investments. The IPO market may start to defrost this year.

The resulting backlog of exits from investments cannot be avoided much longer and it will be important for sponsors to deliver distributed to paid-in (DPI) capital to raise more money. As such, sponsors are exploring all avenues for exit, including secondary market transactions and continuation vehicles, especially when the M&A markets are challenging.

We are cautiously optimistic that increased corporate activity will drive more distribution activity in 2024. The leveraged loan markets have started to recover, and direct lenders are returning more meaningfully to support M&A. And as buyers and sellers watch their companies perform in a tougher market, it will be easier for both parties to agree on a market clearing price. These dynamics have already started to contribute to a meaningful uptick in distributions during the fourth quarter of 2023, and we expect these trends to continue into 2024.

Johnson: As a sizable player in the secondary markets, how have you seen the markets evolve? What are the biggest opportunities and challenges in the secondary markets?

Elio: Global secondary market transactions have averaged $117 billion per year since 2021. Comparatively, the volume was $10 billion in 2009, $42 billion in 2014 and $88 billion in 2019. Under normal market conditions, private equity funds have seen approximately 3%—5% of their limited partner base trade in the secondary market, or 1%—3% of global NAV outstanding. The growing supply of outstanding private equity capital ($11 trillion as of 2023), and a secular trend of rising secondary sales by Limited Partners (LPs) have magnified transaction volumes. These conditions are expected to persist as the secondary market matures and the selling of assets in this space becomes more widespread.

Relative to fifteen years ago, secondary markets currently have more diverse and experienced participants, multiple forms of technology to unlock liquidity, and a growing pool of dedicated secondary capital to provide liquidity. Many private equity investors — including some of the world's largest insurance companies and global financial institutions — are selling partnership commitments and direct assets to generate liquidity, and/or tailor exposures to private market assets. Others — including hedge funds, pension funds, endowments, foundations, and family offices — are seeking to rebalance and proactively manage their portfolios by selling illiquid investments.

As General Partners (GPs) become more involved in directing secondary transactions, firms with a broad private equity platform that have preferred access to information relative to other buyers will be positioned to execute on the most attractive secondary opportunities. We believe GPs are among the most important participants in the secondary markets because of their willingness to provide information on portfolio assets and, ultimately, provide consent to transfers. They are also increasingly utilizing the secondary markets to generate liquidity for investors, allowing them to boost the value of select portfolio companies. Over the past several years, GPs have assumed a more active role in directing or assisting with secondary opportunities to preferred partners. For these reasons, it's our view that the strength and breadth of relationships in the private markets is perhaps the most important currency in the secondary space.

Over the past several years sell-side and buy-side intermediaries and/or brokers have become more involved in the secondary markets. This has increased awareness among sellers, resulting in higher deal volumes and more competition among secondary buyers. Buyers are often corralled through structured processes with only limited access to financial reports, pre-recorded or "silent" conference calls with GPs and tight bid deadlines. Bidders at these auctions often only differentiate themselves by price.

In terms of information, the quality, reliability, and scope of information on the underlying portfolio companies is a critical factor for secondary investments. Since information on private companies is often scarce and closely guarded, full support from GPs is critical. As for leverage, financial institutions are willing and eager to lend to the asset class because highly funded portfolios with broad diversification present lower risks. The early yield and shorter duration of secondary market assets are well suited to interest bearing debt instruments. However, this has also led to widespread financial engineering among secondary buyers to generate higher returns. It is an open question whether if the risk is justifiable, and if the performance of these levered transactions can be replicated across cycles.

Johnson: Secondaries seem to be a useful tool for institutions seeking liquidity in their private market exposures. What's the "catch" in secondaries?

Elio: The increasing use of financing in secondary market transactions poses a challenge for investors who are considering utilizing a secondary partner. Investors should scrutinize how managers expect to achieve targeted returns, with the most common drivers being purchase price discount, asset appreciation and leverage. As competition rose in the secondary markets over the past decade, many buyers accepted higher purchase prices, and sometimes premium pricing, while using financing to achieve their return targets. This strategy can present risks across market cycles because there is little margin of safety, especially if interest rates rise and/or asset values decline.

In the current "higher for longer" interest rate environment, many buyers in the secondary markets believe the rising cost of capital has eroded their ability to utilize leverage to generate returns. This has resulted in higher bid-ask spreads and wider discounts, as more buyers rely on discounts and asset price appreciation. We believe the best performing secondary investments are driven by manager quality, strong portfolio company-level performance, and discount to fair value at purchase. We recommend emphasizing secondary buyers who possess the platform relationships, differentiated insights, and wide sourcing network necessary to buy higher-quality assets with best-in-class sponsors -- and a better chance of generating attractive risk-adjusted returns over long-term cycles.

Johnson: With the emergence of evergreen funds, how are clients utilizing these more liquid funds?

Elio: Evergreen private markets funds typically provide investors with immediate private markets exposure, diversification, and a way to optimize risk/return efficiency in a client's portfolio. We are also seeing various private markets strategies offered through evergreen structures, such as globally diversified private markets solutions as well as more specific private market strategies, such as dedicated private equity, credit, or real assets funds that provide investors with further options for investment customization. Institutions are using semi-liquids as an efficient alternative that replaces their need to staff and execute a direct commitment or fund of funds mandate. We have also seen evergreen vehicles serve as a cornerstone investment for sophisticated investors who desire to maintain a private markets exposure in a higher returning asset class at lower units of risks. Finally, investors in drawdown private market structures have also utilized semi-liquid vehicles to manage their available cash during the period between capital contributions and distributions for their traditional drawdown investments. This enables those investors to optimize return efficiency and lower cash drag.