May 25, 2022
For the first time since 2019, the IVCA Spring Luncheon convened in person on May 18, 2022, at The Chicago Club, and from the enthusiastic buzz in the room there was a gratitude that everyone was together again. The event was sponsored by advisory and assurance firm Baker Tilly and the law firm Ropes & Gray, featuring the topic “What Limited Partners are Talking About.”
Opening remarks were given by IVCA Executive Director Maura O’Hara, and she introduced the expert panel on the topic … moderator Joanna Rupp from the University of Chicago Office of Investments, and the panelists Melissa Richlen of the MacArthur Foundation, Keirsten Lawton of Cambridge Associates, Shari Young Lewis of Aon Investments and T. Bondurant “Bon” French of Adams Street Partners. The highlights of the subjects discussed within the topic and the luncheon participant questions are outlined below …
“WHAT LIMITED PARTNERS ARE TALKING ABOUT” – The Macro View
Bon French: Beginning from 1980, interests rates steadily declined, to the point where in the past 10-12 years it was thought these low rates would never go higher … but they can go higher, we just don’t know when. I’m still at that view today .. because when you start at an interest rate at one, there is really no place for it to go. The benchmarks of 2021, ending on December 31st, 2021, U.S. Venture was up 57% for the year. Buyouts were up 36%. Given the current situation, first quarter benchmarks are down modestly, maybe 5%, with some GPs trending up when reconciling the 4th quarter results of last year.
April of this year was a significant change. In the entire 2021, the U.S. Venture community Invested $342 billion in 16,000 portfolio companies … by far a record. In the first quarter it fell, but only to $71 billion, in 2700 deals, versus $95 billion in 4th quarter 2021. That was a slowdown, but mostly in late stage mega rounds, based on the scale of the dollars.
On the buyout side, deal buying in the first quarter was $222 billion, up from last year. Exit volume, though, was down 46%, to $67 billion, and fundraising for buyouts was down 26%, to $65 billion. Clearly, we’re going into a major re-evaluation and repricing environment.
Many clients here, and advisors to clients, were wondering whether to invest last year at the top of the market. But as we know, unlike stocks and bonds, with Private Equity you’re going to invest for a number of years. So in a sense we’re rooting for a decline in market, as we have a tremendous amount of planned dry powder – as does the industry – to invest into lower and lower valuations. As Warren Buffet famously said, if you have money to invest, why would you ever want the stock market to go up?
Joanna Rupp: The challenge in Private Equity is that we can’t precisely manage those allocations, so if you’re under-allocated with dry powder, today is a great time. Many of us have found that are allocations that are not liquid are perhaps higher than intended.
Keirsten Lawton: The good news of course was that last year Venture was up 50% and Private Equity was up 30%, so hopefully some of those funds were banked. One other observation is that there isn’t much money coming back, so we do expect that there will be an impact from where we’re coming off from last year … the higher valuations, a lot of capital to be deployed and a lot of competing capital.
There is also record unrealized valuations. If you go back to 2016, every dollar you had in your portfolio was probably marked up 1.8 times. Today, if you look at your Venture portfolio, you’re probably marked up 3 times, and it’s probably sitting there unrealized. And if you don’t have those late stage investors coming in, who are price agnostic – just saying they want to pay any price because they’re going after great companies – we’re going to see what price discipline will do to that market.
What we’re hearing in Private Equity, through the first quarter of 2022, is that they’re still going to be up. And it’s still up in Venture, on the whole. But with the latest 30% compression in the Nasdaq, that might set the bar in what we’re going to see next. But with Venture, your public monetary exposure is probably 20-25%, with the rest being those late stage rounds that won’t necessarily compress right away. Historically, both VC and PE are both a ‘slower to increase, slower to decrease’ in terms of valuations.
And the offset of it is that you continue to deploy capital into lower valuation environments, such as now, that’s a major mitigate as you think about your fund exposure and your commitment exposure, which typically is quite large in addition to whatever your math is … I think that mitigates some of the concern there.
I’m optimistic, but it is a good time to have dry powder, and see where we are going throughout the rest of the year.
French: Counter to what I said, I’m very excited about the industry because it’s based on a three legged stool, and one of those legs is technology innovation, which includes life sciences and other areas. We think that’s going to continue. Another leg of the stool is the capital markets, which we cannot control, with dollars averaging both up and down, which is always very important.
Shari Young Lewis: From where I sit, it depends where clients are at … so we have clients who are just for the first time starting to allocate to Private Equity. There is a lot of fund raising, as managers do it every 18 months to two years, that are raising and investing but not distributing as fast. That’s one issue why there is over allocation … and with the tremendous growth rate in the last several years, there is a notion as in ‘what do we do?’
Rupp: How is the MacArthur Foundation feeling about these opportunities?
Melissa Richlen: Basically consistent investing in these up and down cycles since we began in VC and PE investments after 2001. We’ve seen great innovations created during these downturns, so that cash in those funds start to outperform anything in our overall portfolio. We continue to commit to Venture, Private Equity and buyout groups, but we also suffer from the numerator and denominator impact, and we had a fantastic 2020 after a terrible first quarter, and had another great performance in 2021. It’s hard to say we’re over-allocated because we performed well.
We did have record distributions, but at the same time it did fall short of expectations. That skews to more Venture investments than we’d actually like. In March of 2020, we were at about $5.1 billion, so a commitment size for a $5.1 billion dollar endowment are much different, but is has been constant because of good returns. Just to be able to maintain that Venture allocation in our range is where we would like it. As far as distributions, if it continues at the current pace and based on first quarter projections, it will be 30% of the 2021 totals by the end of this year. It’s a challenge without the liberty to add as many Venture investments.
French: You can’t have have a single point target for VC and PE allocations, it has to be a range, like 7-13% … and unfortunately to handle these big capital swings it has to be a large range, and commitment lasts for years. So your investment committees have to be pretty tolerant of these mismatches, which tend to self correct. It’s easy to say that you’ll put in the same dollar percentage every year, but given what I just said it’s very hard to do.
Lewis: We do have groups that just say ‘stop’ or do a massive slowdown, especially after years like 2008-09. But if you did nothing, and stopped for a year or completely, it takes four or five years to really see a difference, and meanwhile they miss what the public markets do … it’s problematic.
French: In 2004, Venture looked terrible, but that was the year Facebook started and investors in that venture – once Facebook went public in 2012 – made VC look good again.
WHAT KIND OF ‘RE-UP’ DECISIONS ARE BEING MADE? Given the opportunities out there, how are you deciding to allocate capital?
French: And ‘re-upping’ is not made for endowments, for example, that support a university’s budget. If there is a big check that comes out of the portfolio monthly, that’s always going to happen. So when you get to these periods where you have some negative cash flows, that’s a struggle because you have to raise liquidity from somewhere else, and that gets scary.
Richlen: In ‘re-ups,’ there are always considerations as to what it on the bubble. But I think it’s more of a quality issue that would put them on the bubble. It’s the qualitative that you keep your eye on for a couple years. We’ve come through a massive time of growth and great returns, anything can happen, and people have forgotten about years like 2008-09. So of course I can invest in Venture funds. What we’ve seen is that it has become more unrealistic. The terms have gotten so far to one side that we’ve actually turned down one of our existing managers. We’re thinking a partnership on a 10-15 year horizon, but what the market is now, and this is what their attorneys are saying. But it should be about partnership.
The real decisions are difficult only because as a foundation, we have a limited set amount of funds. For fundraising cycles, of course there are big investments in year one, and then maybe half the next year, a quarter a year after that, and then maybe it goes up again. With us, that doesn’t work, so we have to trim around the edges.
Lewis: Getting under the hood at another couple levels is helpful. And that is looking at win/loss ratios, valuations at different rounds … and we’ve seen 3 times increases in Series ‘D’ rounds in the last five years that doesn’t seem sustainable, so that could be a haircut, along with the expectations of where you ultimately come out.
On the Private Equity buyout side, it’s a lot more moderate, but we’ve seen 10 times go to 12-14 times, but with interest rates adjusting, that could come down … leverage is less sustainable and interest rates would be more of a burden. We look at valuation and trajectory, so in researching the upper metrics of the company, so you can get an idea of the path of revenue growth – or earning growth if you’re talking about buyouts – and how they are achieving that growth, and how the valuation is tied to performance and potential.
ESG Environmental Social Governance, How are LPs thinking about it?
Richlen: In around 2014, we began to talk to our partners about ESG policies … what do they have in place, do you work such politics into due diligence with portfolio companies, is it more than just a ‘checked box’? We work with a survey provider to give us a score on all our managers. VC and PE are mentorship and apprenticeship businesses, and you need to bring these professionals in at a younger age, while at the same time widening the diversity outreach. We’ve worked to understand our managers plans in ESG in the last couple of years.
French: I’ve found that ESG means different things in different parts of the world. In Europe it’s environmental, in the U.S. post George Floyd it meant the ’S” and more diversity, and in Asia, South American and African circles the ‘G’ is more important. It’s not a one-size-fits-all situation … But if we can measure it, and many evaluations are doing so, it’s heading into a good direction.
Lawton: We have over one thousand clients, and about a hundred are very meaningfully engaged in ESG … it’s about building meaningful portfolios and not just divestment. Today, it’s a much more engaged role. There is a lot of good to be done and we’re seeking that innovation, as well as in PE and mitigation … it’s not just about divestment but how do you make things better? This more proactive approach is really catching on. For example, who would have thought ten years ago that there would be a market for a Tesla? And we’re seeing PE and VC positively contribute to that evolution and engagement.
We’re tracking it in three different ways … looking at Cambridge as a firm, and the GPs as a firm … what’s the carbon footprint and what are the policies? We’re also asking GPs to incorporate ESG into their own strategies. Are you considering ESG when you are buying a company, and once you own that company will there be active engagement? And do they address underserved communities and underserved environmental needs? And we track it across time. Most people buy into the good of it, and there is a case to be made for risk mitigation and positive outcomes … better for the company and better for returns.
CO-INVESTMENT: Is it really all the rage?
French: There isn’t much controversy with co-investments. Adams Street Partners saw 450 co-investment opportunities last year, and went with 35, outputting $800 million. They tend to be fee free and care free, at the same time there are the same terms as the lead sponsor. And the performance is outstanding. It requires a dedicated team and a lot of work, plus it requires great relationships with their GPs. We have a much higher hit rate if we do co-investments with Adams Street GPs than non-Adams Street GPs, and get better information.
It requires jumping on it, giving a quick ‘no’ or reliable ‘yes.’ I think it’s harder for LPs to do co-investments, if they have to drop whatever they’re doing on the primary side, and the scale isn’t usually as large. Even if it’s a successful program from an investment committee or a trustee’s point of view, we still have to question whether it is the best use of our staff time … because we’re unlikely to be able to put out as many dollars with that staff time. But they are attractive, and you just have be dedicated and organized to do it.
Lawton: You do have to frame out the governance approach you’re going to take, the strategy and policy around it, and those can be complicated. What is your investment policy statement and how are you going to execute around it? That includes elements like does your board vote on it? Does your investment committee vote on it? Is there discretion by staff? Can you convene outside of a quarterly process? What is the required amount of work that you’re going to do? If it’s an existing GP can you just say yes when it gets presented to you or do you have to do a dual underwrite … which is complicated, requires a quick engagement and a quick yes or no? Are you going to do it as a fee free and carry free, which about 45-50% of deals still are that, or are you going to engage around things that become more expensive?
Also our opportunities are additive as you think about it … is this a disciplined GP? Do they have insights around industries and the ability to help in a value creation and post investment? That can be additive as you think about underwriting a fund investment as well.
LIGHTNING ROUND … A Variety of Topics with Various Answers
Rupp: Are you considering block chain/crypto focused funds?
Lewis: As far as blockchains are concerned, we do look at managers in the technology and we haven’t done focused funds yet, but we play matchmakers with clients. Our hedge fund team manages that, but it hasn’t gotten to the institutional point, even considering the latest market results. We don’t feel like it’s there yet.
Richlen: We have in the last month allocated a small amount to a dedicated crypto fund, focusing on the blockchain, with a more liquid strategy.
French: Adams Street started investing in dedicated crypto funds as early as 2018, and we’ve made direct investments there, more on the blockchain side than the coin side.
Lawton: I think there is about a hundred funds out there that our clients are investing in, with blockchain as a technology – really interesting stuff if you think about decentralized finance technology. As far as crypto, we’ve had some clients who have invested, but it has been selective.
Rupp: Are you considering secondary sales, and for those advising multiple clients, are they generally more or less interest in secondary sales?
Lewis: We’ve been doing a lot of secondary sales, but it’s a little bit more agnostic to the market. We have discussions, and we advise to stay the course, but we have others who are doing secondary sales for other reasons.
Lawton: We have not, because the managers who are looking to sell we are not active with at this time.
French: Adams Street have been doing secondary sales in the mid 1990s, and recently we’ve done it four or five times, including last year, where there were partial sales … we don’t have anything against the manager nor are we trying to get out of something, but there were some particularly well-timed secondary sales. We were able to distribute a billion dollars more that we would have, back to our clients.
On the buy side, Adams Streets started buying secondaries in 1986, and last year we bought a billion-one of secondaries, and looked at over 800 transactions invested in, because the secondary market is very interesting and has changed.
Richlen: For this year, yes we’re seeing some, because we want some capital to re-deploy.
Rupp: Given the circumstances of the last couple of years, do you prefer annual meetings to be virtual, in-person or a hybrid?
Lewis: I’d say in general I prefer in person. To be candid, when meetings are overly scripted I don’t find them to be valuable, when you’re sitting at home and watching them verbally. In person, of course, people are more real and authentic. You can get something out of virtual, but it is case by case.
Lawton: Personally, I’d say in person, because I haven’t seen anyone but my husband and two kids in over two years. But hybrid is a little more realistic given our current work load, with all the funds in the market.
French: In person.
Richlen: The optionality of hybrid.
Rupp: Have you included cyber security questions in your due diligence?
All said yes.
LUNCHEON PARTICIPANT QUESTIONS
Q: The last several years have seen an influx of new managers, especially on the Venture side. As we head into a re-balancing period, what proportion of the manager landscape do you expect to survive this period, and what will be the hallmarks of those who do survive?
Lewis: The biggest issue is the ability to fund raise, and they’re up against a lot right now, with a lot of different factors. If they have an ability to raise, ideally not having to have an LP take care of the management company, and there are reduced fees, plus we want the LPs to be all equal. The hardest part is LPs supporting emerging new managers, it’s harder when you’re over-allocated, because everyone looks great, and often you have to cut someone who is doing really well to add new ones.
Richlen: The biggest thing for us is when you have a new manager, is that we have to let someone go to slot anyone new, especially when it is tied on allocations. We need to understand how managers differentiate themselves, and why they deserve that spot, and that’s what is able to help their case.
French: We don’t have that issue, but we have managers in Europe, Israel, Asia and so forth. But there is concentration in the U.S. especially, as 80% of the dollars are with the top 20 Venture managers. In that sense, it’s the haves and have-nots. We still back up spin-offs, one man bands and such … we see the upside in start-ups of smaller funds as well. So we’re doing both.
Lawton: As we look at the top ten funds in any year, there are emerging managers with returns, and it’s always going to help us. GPs historically step back often and wonder where their edge or angle is, so there has to be that differentiation for sustainability.
Lewis: What is the alignment between those who put out a shingle and are out to prove themselves, versus groups who are constantly raising funds and are bigger and bigger? They’ve done well, probably, but where is the alignment and who is really driven toward exceptional returns? Personally, I think emerging managers are more so in pursuing that alignment.
Q: What are the changes in the secondary market?
French: In 2021, there was $132 billion traded in secondary market, by far a record. And in first quarter 2022, on a quarterly basis, it was even bigger. In 2021, $68 billion of the $132B was GP led. So this is indicative of a whole other avenue for liquidity. What these big secondary players are dealing with is highly concentrated portfolios – those that are GP led – it might only one or two or three companies, which does not include the wide or diverse portfolio of LP interest.
There’s a lot of power in the secondary market right now, but there is a shortage of capital at the same time, because of the concentrated portfolio dynamic going on. What a foundation or university endowment has to think about in portfolio sales for liquidity, is is what they have to sell big enough to draw interest for someone in the secondary market? We’re finding that even a 100 million doesn’t draw interest.
Lewis: On the other end, we are finding buyers for smaller portfolios, and they are getting discounts. The secondary market has changed simply because there are different types of buyers.
French: And secondaries provide liquidity that you otherwise wouldn’t have.
Q: What is the status of balance for women GPs and persons of color?
French: We have $4.2 billion dollars allocated to minority owned or women-led GPs or portfolio companies combined, and it’s done very well. It’s not as much as a social issue as finding great talent in different places. We’re 100% employee owned, and 60% of our employee owners are women or people of color. So white men are the minority.
Richlen: Over the past four years, we’ve been going into different networks, within minority and diverse managers. Many of them are smaller, and we invest in $50 million or above. So what we have done is maintain communication to hear what these minority and diverse owned funds are doing, and stay close to LPs and ask them advice. We’re also looking for a relationship long term, beyond just funds.
Lawton: The percentage is 1.4% of capital is managed by diverse-run firms, and 40% of the U.S. is ethnically diverse, so clearly there is a lot of work to be done, but also there is opportunity being missed. There is an impetus for us to make sure that the teams we’re backing reflect the diversity of our society … we have the conversation, it’s just the convincing for more diversity that needs to happen.
Lewis: Today it is easier, but my concern is that investors are not just ‘checking a box’ and providing long term capital.
Rupp: I always tell people you’re not fundraising, you are friend raising.
If you missed it, an audio recording is available for IVCA members HERE!