Calling all LPs! Thanks for joining me (John Bailey, Co-Founder at OneFund) for another edition of Capital Call. A bi-weekly private equity newsletter from LPs for LPs. 

The mission of Capital Call 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: 

• An Update to Middle Market Tailwinds

• Fundraising updates and VC/PE reports

• GP Perspectives from David Cahn & Henry McVey

Join us for an upcoming webinar with Fortress Financial Partners!

As part of our ongoing Fall webinar series, we will be sitting down with Chris Gure from Fortress Financial Partners on Thursday, October 5th at 3 pm!

In addition to answering any Q&A you might have, the discussion, Uncommon Returns: A look at private equity, will cover…

• How PE and VC are different than public stocks

• PE and VC’s advantages and disadvantages

• Chris will deep dive into some unique tax benefits.

An Update to Middle Market Tailwinds

Pitchbook’s Q2 update on the U.S. PE middle market describes the sector as “firing on three of four cylinders” as it continues to shine across several measures despite being in a down market amid historically high rates. These mixed signals for middle market PE is relatively unique. In this week’s Capital Call, I'll analyze the key themes Pitchbook highlights in their Q2 middle market update and provide actionable takeaways for LPs and some of my thoughts. 

Market Share, Fundraising, and Performance are Firing Strong 

The outlook for middle-market PE is stronger than ever. The share of middle-market buyouts just reached new highs, fundraising is positioned to overtake 2019’s record high, and middle-market PE fund returns have exceeded megafund returns for three straight quarters. 

Regarding market share, middle-market buyouts now comprise an astonishing 75.6% of all PE buyouts and 68.9% of all PE deal value. Middle market lending is being actively served by the growing web of private credit lenders, including private debt funds, BDCs, and other credit vehicles.

This has been helping deals get done and while middle market performance is relatively high now, there is some concern that middle market heating up could lead to downward pressure on returns down the line as surplus dry powder is spent amonf higher rates. Given the competitiveness to create value, LPs should ensure their managers are able to take full advantage of private credit’s heightened interest to finance the sector and leverage it to negotiate more favorable fee terms. 

Fundraising in the first half of 2023 is on track to beat 2019’s record high as LPs pour capital into the middle market due to more attractive valuations, less complicated leverage structures, and a broader shift away from top megafunds to reduce manager concentration risk. The $78.5b raised in the first half of 2023 implies a run-rate annual figure of $157b, surpassing the $153.2b record set in 2019. The middle market continues to provide compelling investment rationale, but LPs should ensure that the recent interest doesn’t give GPs too much market power in regards to management and performance fees. Additionally, middle market managers with undifferentiated strategies could struggle to generate returns as rising rates make returns from financial engineering more challenging to generate.  

The One Cylinder that Isn’t Firing: Exits

Middle Market PE has strengthened across various metrics over the past quarter, but exit activity in Q2 2023 slumped to the weakest level since 2010. At the end of the day, exiting companies and generating dividends for LPs is the name of the game and funds will need to do this at some point. The lack of exits is in part due to a mix of GPs holding out for better returns and facing deal structuring challenges on exit. Pitchbook notes that many deals fell through this quarter due to withdrawn bids, distressed prices, and volatility in debt markets. If this persists, the happy days for middle market funds will wither. To avoid a new normal of slow exit activity over the foreseeable future, GPs and LPs alike should consider executing alternate liquidity solutions at scale, including carve-outs, NAV loans, secondaries, and more. 

Updates from Across the Ecosystem

Fundraising

📈 EnCap sets $2bn target, $2.5bn cap for second low-carbon energy fund

📈 SkyKnight Capital racks up $1bn for fourth fund

📈 Blue Sea Capital racks up $618m for third fund

Reports

🔬Morgan Stanley: The Rise of Private Equity in Tech M&A

🔬Pitchbook: Do VC specialists outperform generalists?

🔬Bain: A Buyer’s Market Is Coming for Tech Assets

GP perspectives:

David Cahn (Partner, Sequoia Capital)

David Cahn, a partner at Sequoia, poses an interesting calculation for AI CapEx. For every $1 spent on a GPU, ~$1 needs to be spent on energy costs to run the GPU in a data center. Therefore, Nvidia generating $50B in run-rate GPU revenue by the end of this year implies roughly $100B in data center expenditures. The end user of the GPU, such as Starbucks, X, Tesla, Github Copilot or a new startup needs to earn margins as well. Assuming they need to generate a 50% margin, each year GPU CapEx represents $200B of lifetime revenue that would need to be generated by these GPUs to pay back upfront capital investment, not including any margin for cloud vendors.

Cahn believes AI only generates $75B today, which uses generous assumptions, leaving a $125B+ gap that needs to be filled for each year of CapEx at today’s levels. Though there’s a large opportunity for the startup ecosystem to fill this hole, this major gap implies a technological overbuild that will likely incinerate capital, while paving the way for future innovation at the same time. For investors, there’s likely a significant opportunity to deploy capital in certain, strategic AI companies, but be wary that many firms operating in this space will burn significant capital over the next few years without much to show for it.

Henry McVey (Partner & Head of Global Macro, KKR)

Henry McVey believes private investors will increasingly flock towards real assets as bonds lose their portfolio ‘shock absorber’ effect due to fixed income performance becoming more correlated to equities. McVey favors real asset funds and direct investments instead since they offer defendable margins and recurring yields that can substitute traditional fixed income.

However, not all Real Assets are performing equally and many traditional inflation hedge assets are underperforming. McVey believes investors should look beyond traditional real assets such as REITs, TIPS, and Gold and instead consider collateral-based cash flows linked to nominal GDP, such as infrastructure and energy. Private investments in real assets can not only bring financial performance but also strong diversification due to its lack of correlation to other funds LPs typically invest in.

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