At the end of the year we sent out a short survey to learn more about investors’ headline concerns about the private capital markets today. Investors also shared their expectations about returns and where they see their allocations to various private strategies trending.
(The top five industry concerns, in rank order)
“Prices are getting frothy” (the valuation uptick of purchase price multiples being paid in some sectors, strategies and regions);
Fees/terms (the general direction of fees, expenses and alignment becoming more balanced between GPs and LPs);
“Growth of fund sizes” (the overall increase in fund sizes from one fund to the next in some segments);
“Capital overhang” (the amount of committed capital but not yet invested, especially in the large end of the market); and
Difficulty in accessing top funds (quality matters and can help drive success).
We agree with these industry concerns and others raised in the survey and take them into account every day in how we design and build investor portfolios.
Our Perspective on Each Shared Concern
Like the public equity markets, increased valuations in some private capital sectors cannot be denied. This requires us to “pick our spots”, especially in areas where we see relative value and tilt our investment point of view, accordingly. In venture capital, for example, we prefer early stage, rather than later stage investments, where industry valuations have increased.
Private capital is expensive – but we believe worth it when you can access and work with industry leaders to achieve a goal of the three percent premium over the public markets over the long term. That said, to help drive returns and to lower the overall fees paid to managers, we continue to favor increased allocations to capital efficient strategies, such as secondaries and co-investments. We continue to evaluate managers on their “net” results — and for some premium managers that we partner with, we believe premium fees are worth it on a net return basis.
Growth of Fund Sizes
Generally we believe that investors should tilt their commitments towards smaller and medium-size sector specialists that focus on investment success as their primary wealth creation driver (as opposed to fee revenues generated on large fund sizes). Many of these smaller firms are capacity constrained and tough to access. It is our view that researching and accessing a basket of smaller firms and sector specialists makes for a robust portfolio — especially when complemented with secondaries and co-investments alongside high conviction managers. We believe the labor involved to network, source and research such managers can lead to compelling portfolios and results.
Capital Overhang (or “Dry Power”)
We, too, are keeping a close eye on the so-called “capital overhang” — especially in the large end of the market that dominates the “dry powder” in the industry. The smaller and mid-size segments represent a smaller share of the overhang. In past cycles, the “relief valves” for such overhangs have been driven by new investments and follow-on investments into portfolio companies. We also have witnessed larger firms buying small and mid-size portfolio companies held by the smaller and medium size managers.
Accessing the best managers requires hard but critical work. For three decades we have promoted three key principles of private capital investing:
Dollar-cost average across vintage years and cycles — and do not try to market time;
- Private strategies — venture capital, private equity and natural resources;
- Geographies — US, Europe and other developed markets (like Japan and Australia) and select emerging markets (like China, India, and parts of Latin America, Central and Eastern Europe and Africa); and, most importantly;
- Focus on accessing quality managers.
Research and access best of class quality managers to build portfolios around the “best” versus the “best available”.
We believe that institutional investors that are charged with achieving CPI + 5% returns to sustain their missions, or to meet their spending objectives must use their size and long-term investment horizon to their advantage. A disciplined and consistent program of including private capital investments in the portfolio to capture the premium that they can offer over public equity markets can be an important contributor to these pursuits.