Topic Tags: Private Equity

The Growing Appeal of Co-Investment Funds

Co-investment funds are becoming an increasingly attractive area of deployment within private equity programs. The number of dedicated co-investment vehicles has risen dramatically over the past decade as many fund-of-funds managers have looked for product expansion and have responded to investor demand.

Co-investment vehicles provide investors the ability to provide additional capital — alongside and aligned with private equity managers ­— at a significantly reduced fee (less than traditional private equity investing) and with quicker deployment (mitigating much of the j-curve). These factors have contributed to the higher net returns recorded by dedicated co-investment funds over this past decade.

As seen in the charts above, these dedicated co-investment funds have outperformed the broader private equity fund performance with a higher median net IRR of 18.9% (430 bps of outperformance over Preqin’s direct private equity median net IRR) and with 80% outperforming their median PE performance within their respective vintage years (2009–2016). We believe this past decade has really proven out many of these teams and strategies and that proven managers with strong and repeatable selection processes should continue to outperform private equity benchmarks in nearly all vintages throughout a full economic cycle.

We encourage investors to continue to allocate to these dedicated co-investment funds as an important allocation within their private equity programs. However, we caution investors must be selective as there is a very wide range of skill, sourcing, alignment, and access differential between managers within this area of the market.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

The Rise of Co-Investing

Much like the overall private equity ecosystem, the private equity co-investment landscape is undeniably growing and has yet to show any signs of slowing down. Historically, co-investing was implemented for one-off decisions to fill the gap in financing that GPs were unable to obtain. Now, GPs have come to embrace co-investment capital with a more recent phenomenon pushing its way to the forefront. We are now seeing GPs form dedicated co-investment vehicles, which eliminate the need for GPs and LPs to negotiate terms for each transaction. This structure gives co-investors access to a stream of co-investment opportunities with preferential economics.

Co-investing is beneficial to not only the GP, but also to the co-investors (LPs) who benefit from high-quality investment opportunities at favorable economics. Co-investing allows LPs to commit capital alongside preferred GPs and create tactical allocations to a pool of high-quality investments for their portfolios. Additionally, the more appealing fee structure of co-investments, which often have no management fee or carried interest, is fueling demand from institutional investors.

The value of co-investment deals has more than doubled since 2012 (totaling $104 billion in 2017) with the number of LPs making co-investments in PE rising from 42% to 55% over the past five years. In 2017, roughly 20% of the private equity market accounted for this volume. The volume of co-investment deal value in recent years has increased rapidly, illustrating the growing appetite investors have for this space.

Given the competitiveness of the co-investment market, having the right GP relationship is of utmost importance and a major determinant in the success of a program; however, given the size of the maturing private equity co-investment marketplace, we encourage investors to — at the very least — retain the option to pursue co-investments as even a modest allocation to the space can improve the return profile of a private investment program.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Venture Capital Benefits from Mega IPOs

The first half of 2019 has produced a number of high profile IPOs including Uber, Slack, Pinterest, Zoom, Beyond Meat, and Lyft. These IPOs have made it a very successful year for U.S. venture capital exits. While the absolute number of exits has remained slightly below the pace of recent years, this year’s exits have been larger, generating nearly $190 billion through the first half of 2019. This year’s second-quarter exit value alone has exceeded the annual amounts for the venture industry going back to 2006. IPOs have accounted for nearly 83% of the cumulative exit value so far in 2019.

This strong exit environment is likely to allow U.S. venture capital to repeat 2018 as the strongest area of performance within the broadly defined private equity market. While we expect the first quarter to provide strong returns, the second quarter is where we will see a significant increase in performance as IPO offerings ramped up in the spring/early summer. With a robust remaining pipeline of potential IPOs scheduled for the second half of 2019 and 2020 including Airbnb, Palantir, Robinhood, Postmates, and WeWork, we do not see this market cooling off much in the near-term. Regardless of which of these remaining high profile IPOs materialize this year, 2019 is likely to be remembered by investors as the year of mega IPOs.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Second Quarter Review of Asset Allocation: Risks and Opportunities

Overall, the second quarter was positive for financial markets, thanks to strong economic fundamentals and expected Fed stimulus. Unemployment remains low at 3.7% and inflation (1.8% year over year) is near the Fed’s long-term target of 2%. However, there are increasing concerns about a global economic slowdown and early forecasts for 2Q GDP growth are around 1.5%, far lower than what we’ve seen in recent quarters. Globally, the most important trends we see are the following:

  • The U.S.-China trade conflict remains ongoing as talks between the two countries resumed, but little progress has been made;
  • The Federal Reserve is expected to cut rates in July and markets are forecasting another one to two cuts by the end of the year;
  • Business sentiment is declining ­— most notably in the PMI manufacturing index, which is now dangerously close to falling below its growth threshold;
  • Britain continues to struggle with its Brexit and elected a new PM (Boris Johnson) on July 23rd;
  • China and Europe are expected in increase their stimulus measures to combat slow growth and overall global uncertainty;
  • Late-cycle dynamics in credit and equity markets.

The impact of these trends is explored further in this newsletter as we review second-quarter performance and expectations going forward for each of the major asset classes.

Read > Second Quarter Review of Asset Allocation: Risks and Opportunities

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

The Evolution of Private Credit

With roughly $48B of U.S. private credit fundraising taking place in 2018 ­­— surpassing 2008 levels of $42B — private credit has established itself as an up-and-coming leader within the alternative space. By 2023, private credit is estimated to reach $1.4T in AUM, becoming the 3rd largest alternative asset class. This kind of success has brought with it increased competition, robust inflows, rising pools of dry powder and an inflow of managers within the space, up from 31 managers in 2010 to more than 130 in 2018.

The growth of available capital in the private credit market has been substantial, but the growing demand for debt has kept the opportunity largely intact. Direct lending, which is more prevalent in the middle-market, has rapidly developed into a meaningful source of debt capital within the private equity (“PE”) ecosystem.

Since the global financial crisis, the leveraged loan market has become less accessible to middle-market companies as banks have generally stopped lending in this part of the market. The volume of leveraged loans held by banks reached roughly 30% in 2008 and has since declined sharply to less than 10% today. Coupled with a 48% drop in the total number of U.S. banks from 1998 to 2018, demand for direct lending has increased as U.S. banks have substantially withdrawn from the market.

In their relentless search for yield, institutional investors stepped up in a meaningful way vis-à-vis direct lenders, and while highly competitive right now, direct lending brings PE-style returns with heightened levels of downside protection. Because private credit investments can be approached in a defensive, risk-controlled way, private credit is especially well suited for late-cycle conditions, and with its higher coupons, robust cash flows, and lower risk profile, we can expect private credit to continue to grow at an accelerated pace and become a consistent component of an increasing number of institutional investors’ portfolios.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

IPOs Are Coming

This year has seen a burst of unicorn IPOs paving the way for Uber’s IPO later this year. While Lyft, Zoom, and Pinterest shared Uber’s unicorn status, they have had very different rides post-IPO in the stock market.

The market’s appetite for IPOs appears strong after a bumpy end to 2018, but one of the most recent unicorns to go public, Lyft, has struggled. After going public on March 28, the stock is down 22%, and 28% from its peak. Some analysts have pointed out that Lyft may have misled investors by claiming it held 39% of market share, as another survey reported 29%. Though the IPO ‘pop’ is well known, this is usually followed by a slow decline, so Lyft’s stock price behavior is not shocking. Zoom and Pinterest took note regardless, pricing their IPOs a bit more conservatively. Lyft priced its IPO at over a 30% premium compared to its last pre-IPO valuation, while Pinterest and Zoom went with about 2% and 17%, respectively.

Performance aside, 2019 is off to a strong start for IPOs with many more either expected or suspected including Uber, Beyond Meat, Airbnb, Slack, and Poshmark. The rest of the year should bring its share of further IPO excitement as more large, private companies seek to bring their investors liquidity and raise additional capital.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

First Quarter Review of Asset Allocation

Heading into 2019, the primary risks facing financial markets were the trade war with China, the U.S. government shutdown, Brexit uncertainty, and further Fed rate hikes. However, in the first quarter the majority of these worries subsided.

In this newsletter, we analyze the current market environment with a review of recent performance and future expectations for each major asset class. As always, we caution investors to stay diversified and rebalance as appropriate. There are always potential disruptors to the financial markets and the most powerful tend to be largely unexpected. We will continue to monitor markets and developments as they occur to guide our clients to the most optimal portfolio decisions given the backdrop of program goals and risk tolerance.

Read > First Quarter Review of Asset Allocation

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

The Latest Key Developments in the Healthcare Industry

Health systems today face significant challenges, further complicating an ever-changing landscape. Some of the most notable trends we see in the space include:

  • Higher interest rates, which impact borrowing costs as well as investment opportunities;
  • Efforts to gradually repeal the Affordable Care Act (“ACA”);
  • The emergence of value-based payment programs;
  • The advent of major vertical integrations such as CVS-Aetna;
  • A growing demand for digital healthcare

The following article summarizes these key issues for health systems and where appropriate, provides some potential solutions.

Read > The Latest Key Developments in the Healthcare Industry

With over 20 years of healthcare investment consulting experience, Marquette serves healthcare clients across a broad range of operating cultures — including health systems, stand-alone hospitals, and specialty organizations — and with a variety of focus areas — including operating funds, retirement planning, insurance, endowments, and foundations. For more Marquette coverage of the healthcare industry, please see our previous newsletter Healthcare Organizations’ Top 3 Investment Concerns for Balance Sheet Assets.

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Will Opportunity Zones Encourage Investment and Economic Growth?

In an effort to attract capital and encourage long-term investments in low-income urban and rural communities, Congress reformed the Tax Cuts and Jobs Act of 2017 to establish Opportunity Zones nationwide, which could offer a tax break for investors. The chart above shows the number of Opportunity Zones in each state. Congress had tried similar approaches in the past with Empowerment Zones and Renewal Communities, but this most recent effort is receiving unparalleled levels of attention for its generosity to investors and lack of governmental supervision.

Under this program, investors can re-invest their unrealized capital gains into a Qualified Opportunity Fund within 180 days of realization to receive numerous tax benefits. These benefits include potentially excluding up to 15% of invested gains from taxation (10% if held for 5 years, 15% if held for 7+ years). An investment held for longer (at least 10 years) is permanently excluded from taxation. In addition, capital gain taxes can potentially be deferred until 2026.

Given the infancy of the program, many have pointed out flaws within the initiative, stating there is a disconnect between the social benefits from the investments — which will be difficult to measure — and the size of the potential tax costs, which are uncapped. However, it will be for some time until it can be determined whether the program is effective and advantageous for investors, given Congress has asked the IRS to begin reporting on the program’s operations in 2022. Ultimately, this program bears watching as it could be an attractive opportunity for investors and asset managers while also encouraging growth in depressed areas of the country.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Will Correlations Between Private Equity Strategies Continue to Converge?

Private equity and venture capital allocations have together benefited private capital investors as they have individually provided outperformance at different points throughout an economic cycle. While both are loosely correlated to public equity performance, venture capital investments have many similarities to growth allocations whereas private equity buyout investments have characteristics similar to value allocations. Buyout returns often depend on lower purchase prices and leverage to generate excess returns, while venture returns tend to be less price sensitive and a reflection of accelerating growth.

The lower correlation between the two assets classes was present for more than a decade, spanning from the 1990’s to the early 2000’s. During this period, an investor would naturally hedge against the heightened volatility in venture by investing in both asset classes to offset this risk. However, since the mid-2000’s these two asset classes have become much more correlated as they both have benefited from a strong, 10-year plus growth-oriented environment coupled with low fixed interest rates.

While correlations have tightened over the past decade, the “growthy” economic backdrop that has fueled this relationship will undoubtedly come to an end. When this occurs, we believe these two asset classes will provide a nice complement over time to investment portfolios in generating a higher overall return with less volatility.

Print PDF> Will Correlations Between Private Equity Strategies Continue to Converge?

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.