What LPs need to know about private market performance

By Jacob Wilder
July 20, 2018

Timelines are expanding, deal sizes are growing, funds are getting larger and the private markets are providing higher returns. But what does this mean for your allocation strategy?

See how different investment strategies are performing in today’s changing private market investment ecosystem—and see where you might want to invest capital next. Get a closer look at the market dynamics impacting contribution rates as well as differences between venture capital and private equity.

Performance trending positively for most private market strategies

Most private market strategies are trending positively, with significant upticks across investment strategies in the last year. Private equity is showing especially strong performance—reaching a whopping 19.1% 1-year horizon IRR at the end of Q2 in 2017. For reference, the S&P had around 15% IRR during the same period.

Though secondaries performance didn’t reach the same height as PE, the strategy showed marked increases from 3Q 2016 to 2Q 2017, ultimately arriving at a healthy 14.2% 1-year horizon IRR by EOQ 2Q 2017. As the market becomes more competitive (with additional players and higher prices in recent quarters), assets are continuing to trade closer to par value with their underlying net asset value (NAV).

Despite falling from early 2015 levels, VC 1-year horizon IRR has been increasing as of early 2017, reaching a respectable (though relatively lower) 7.5% return. This recent activity is largely due to an increase to residual, remaining value in VC portfolios (often in the form of unicorns that haven’t exited yet).

While PE, VC and secondaries continue to rise, debt has taken a downward turn. One explanation is that private debt assets are held into maturity—so they don’t get the same benefit that other strategies get when there is a boom in public equity markets. Looking at things from a higher level, it’s possible to see that secondaries have actually outperformed other strategies over the past 10 years.

When you zoom out and look at investment strategy performance across a longer time horizon, it’s possible to see strategies converging—except for secondaries. There hasn’t traditionally been a lot of competition in this space, but things are picking up. A strong investor appetite for private debt funds and secondaries, plus record levels of fundraising combine to create this demand.
 


Rolling 1-year horizon IRRs by strategy Most private market strategies are trending positively, with significant upticks across investment strategies in the last year. Source: PitchBook


VC funds are investing capital and generating distributions faster than ever

Beyond overall performance by investment strategy, it’s also important to look at the relationship between valuations, deal sizes and the speed of VC capital calls. Overall, VC firms are investing and calling down capital faster than ever as valuations and deal size are on the rise. Call down rates show a 120% increase in median late-stage valuation since 2009.

At each measurement period, VCs have called down more capital than prior VC vintages. Plus, deal sizes have also increased over the past decade. In fact, almost half of all VC rounds now exceed $50M, compared to about 20% that exceeded that amount a decade ago. In addition to larger deal sizes, fund sizes have also increased. In an effort to counteract the current VC climate, firms have been raising larger funds. Despite this attempt, capital is still being called down more quickly.

Even with an uptick in call downs, a lot of capital is still being held in funds. For instance, in the 2008-2011 vintage above, DPI is still well below one (so there’s lots of unrealized value). Moving forward, it’s even more important to be aware of just how much unrealized value there is in these funds as their timelines expand.

As a counter measure, many firms are looking to the secondary market. With more activity across the board, this is an area that is becoming increasingly prominent. For example, VC-backed companies are more regularly pursuing alternative exits (such as Spotify’s recent direct listing). This approach has gained some popularity as it allows VCs to take some capital out of their investments and return it to investors without a full exit (which is especially important seeing as VC-backed companies are staying private longer).
 


VC called down % over time by vintage bucket At each measurement period, VCs have called down more capital than prior VC vintages. Source: PitchBook

PE slowly calling capital down

Private equity call downs tell a completely different story from VC. More than before, PE dealmakers are actually drawing down less capital as they complete deals. By the fourth year since inception, the most recent vintage was about 7-8 % behind in terms of call down. But beyond calling down capital slowly, we found that the current PE median EV/EBITDA is a hefty 8.7x—the highest we have on record.

So, why are call downs slowing? From a fund management perspective, part of the explanation for this is that we’re seeing PE investors get closer and closer to deals, while overall high prices persist. To more effectively make direct investments, many investors are building their own internal PE teams. This is especially true for larger, more sophisticated investors who have the means the expand their firms. Similarly, there is now a stronger preference for co-investment opportunities where possible.

It is taking longer to complete add-ons, but more add-on deals are also happening (and more add-ons are being completed per platform company). In fact, an impressive 70% of all buyouts in the US (for 1Q 2018) were add-on transactions—which may also contribute to extending hold times (and investment timelines) for platform companies. For most fund managers, the hope is that completing additional add-ons will increase returns for lower middle market companies that would otherwise trade at lower multiples (if those add-ons can be integrated into a platform that can be sold at a higher multiple later).

Obviously, extended investment timelines in private equity are also affecting returns. Instead of the textbook example of an average hold time of 3-5 years, we’re seeing an average of 5.9 years. Beyond PE firms taking longer to return capital to LPs, the overall profile of these exits is changing.

As prices continue to rise, firms are getting more creative in how they source deals. For the first time, secondary buyouts made up the majority of PE-backed exits (an interesting development in the exit market) as strategics make up fewer liquidity options. More frequently, secondary buyouts are being used as a deal sourcing technique. Despite the shifting exit environment, PE and VC-backed IPOs have remained strong in recent quarters—altogether pointing towards a future that may be rich with liquidity opportunities.
 

With so many options, how do you find the right fund manager?

How to mitigate risk with the right private market data →


With so much competition, how do you get in front of top-tier funds?

How to identify top-performing funds—first →


Learn more: The data institutional investors need to tap into private capital—while mitigating risk

 

Related content