Calling all LPs! Happy New Year and thanks for joining me (John Bailey, Co-Founder at OneFund) for another edition of Capital Call to kick off 2024.

The mission of Capital Call, our bi-weekly private equity newsletter from LPs for LPs, is to deliver concise, top-notch insights and updates from the private markets tailored to what matters for LPs.

This week we will be looking at: 

• 2024 PE Outlook

• Fundraising updates and Macro/PE reports

• GP Perspectives from Howard Marks, David Cahn, and Mo Hassain

2024 Outlook: Continuation Funds and Founder-Owned PE in the Spotlight

Private equity in 2023 has been defined by a dealmaking slowdown, limited exits, and illiquidity. Despite being a down year though, the industry saw several silver linings in areas of the market that remained strong including North America, the middle market, and technology. In addition, most analysts and GPs feel confident about the year ahead as macro challenges ease.

So what’s in store for 2024? We’ll likely continue seeing a mixed bag as 2023 headwinds persist, but challenges will ease as the expected full recovery ensues. In today’s newsletter, I’ll cover the forecasts made in Pitchbook’s 2024 Private Equity Outlook and discuss the insights that matter most to LPs.

Continuation Funds Will Hit Critical Mass

US PE exit activity reached historically low levels in 2023, with only $227 billion of the industry’s $3 trillion reaching exit. With just 7.6% of beginning AUM exiting, this represents the lowest level recorded, even worse than during the Global Financial Crisis in 2009. The two traditional routes for exiting portfolio companies, such as M&A and public listings, have frozen due to interest rates and negative liquidity conditions.

PE is facing a time crunch to wind down portfolio holdings, as finite-life funds typically last a maximum of 10 to 12 years. To address this challenge, alternative liquidity solutions have provided a third exit route, as net asset value (NAV) financing, portability term loans, PIK loans, structured debt, mezzanine solutions, secondaries, and continuation funds gain popularity.

Out of these options, continuation funds are emerging as the favored solution as 2023 saw 71 exits through continuation funds, with analysts predicting this to soar to 100+ continuation fund exits in 2024. These funds provide liquidity to LPs while giving GPs more time for effective portfolio management, and the strategy is backed by significant dry powder.

However, the continuation fund process is not without risks. It can be controversial and faces resistance from LPs, who can be forced into selling their co-investments at a discount or rolling it forward to a continuation fund that comes with higher fees and carry.

How Should LPs Think Through This?

LPs should consider carefully whether fee structures align with their original investment thesis before stepping into a continuation fund. LPs may be in a position to bargain more favorable terms than presented, especially if they are major investors in the fund.

Due to LP conflicts, roughly one-third of continuation processes reportedly failed in 2023. LPs should treat continuation fund opportunities with the rigor of a new investment, and determine the option that best aligns with their interests.

Founder-Owned Transactions to Grow Even Higher in 2024

Non-backed companies, which are traditionally family or employee-owned, represent a majority of US PE deal activity at 56.1% of total deals. This figure is a significant increase from 45.5% in 2021 and signifies the growing trend towards founder-owned companies.

This resurgence follows the dip during COVID-19 when PE interest in non-backed companies decreased due to their perceived vulnerability to financial shocks. The current trend follows a major strategic shift among PE investors who are further prioritizing operational improvements over heavy financial leverage, realizing higher interest rates are here to stay.

Founder-owned businesses, which make up a significant portion of non-backed companies, continue to offer PE investors a clean slate for value creation opportunities and are transacting at significantly lower purchase price multiples. This cost advantage is particularly attractive amid higher borrowing costs.

With PE firms' dry powder reaching over $1 trillion with a limited pool of available sellers, the incentive for PE buyers to actively seek non-backed targets is growing. However, the trend may face risks if market conditions change. 

An improvement in access to leverage or a reduction in price dislocation or could shift the focus back towards larger deals involving various backing statuses. Conversely, economic uncertainty or a potential recession in 2024 could lead to forced selling across different backing types, reducing the proportion of deals involving non-backed companies.

How Should LPs Think Through This?

The latest performance data shows middle-market buyout PE outperforming megafunds for over four consecutive quarters. As seen in the chart, middle-market PE achieved 8.7% IRR vs. megafunds’ 6.4% IRR over a one-year horizon. It will be interesting to see how this persists though as the economy improves. My hunch is that it will reverse.

Returns of the two market segments are converging as the benefit of public market rallies and scale are trickling to larger funds. This typically aids larger exits either through IPOs or justifying enhanced exit multiples, which are usually discounted in the mid-market.

As a result of strong performance, middle-market dry powder reached a record $475 billion due to successive rounds of strong fundraising. Analysts notice that new managers are being given more opportunities than last time the PE market was under stress, as long as they can raise over $100 million and demonstrate a differentiated strategy and higher alpha than other buyout offerings.

How Should LPs Think Through This?

With higher rates to remain through the medium term, the proportion of founder-owned deals will likely stay elevated, even if access to leverage improves marginally. Therefore, LPs without exposure should consider strategies in the middle market that allow access to founder-owned transactions.

When conducting diligence on GPs, LPs should assess how they actively pursue acquiring founder-owned businesses. Those who can leverage vast personal networks to source deals will have an edge over those who rely on investment banks and other sell-side advisors. 

Updates from Across the Ecosystem

Fundraising

• Banner Ridge Partners raises $2.15bn for 5th Secondary Fund

• Goldman Sachs wraps up Debut Life Sciences Fund at $650m

• AlpInvest and Leonard Green close $2bn for New Continuation Fund

Reports

• Bain: Global Recession Watch, The Latest Data

• BlackRock: 2024 Private Markets Outlook

• Oliver Wyman: 10 Ideas In Asset Management For 2024

GP perspectives:

Howard Marks (Co-Chairman, Oaktree)

In the latest Oaktree podcast, Howard Marks answers the question of what is a “normal” environment. Over the past 43 years, interest rates have been on a decline and near zero, leading most to consider this as normal. However, Marks emphasizes the importance of historical context and recognizing how the current period differs from the norm.

Many GPs will inevitably forget that “normal” rates were much higher prior to 1980, and believe the strategies that worked well over the last 43 years will continue working in the higher-rate environment of today. Considering most GPs haven’t been around for that long, many won’t even think to adapt to a new investment framework.

In reality, if interest rates are no longer consistently declining and as low as they were in the past, then strategies that worked during that period will not be as effective going forward. Marks provides the quote from economist Paul Samuelson, “When events change, I change my mind. What do you do?” 

David Cahn (Partner, Sequoia Capital)

David Cahn, a partner at Sequoia, believes that AI is still in the early stages, or "primordial soup phase," of development. The frenzy that marked 2023 tech investment will cool and only the truly impactful companies will remain.

For 2024, Cahn envisions building on existing AI foundations, such as transformers and GPUs, to discover new investment use cases. The focus is on converting AI's potential into real solutions, with Cahn forecasting 2024 to be a reset year for the industry. Those focused on quick exploitation will lose steam, while founders engaged in deep exploration toward value creation shall pull ahead.

All PE participants need to track the AI revolution, as it’s a driving force behind the surge in tech PE that is keeping the broader private capital aloft. AI’s success or failure will inevitably influence broader PE performance.

Mo Hassain (Managing Partner, Ennovance)

Mo Hassain notes the large increase of secondary funds fundraising. Notably, fund sizes have more than doubled last year, mostly due to significantly larger sophomore funds following a successful first fund. 

For LPs interested in secondaries, there will surely be many fund opportunities to diligence and commit in 2024.

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