Calling all LPs!

Welcome back and thanks for joining me (John Bailey, Co-Founder at OneFund) for the third 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 current and prospective LPs. 

This week I will be looking at: 

• How LPs should be identifying risks in a dynamic environment 

• Fundraising updates and VC/PE reports from firms such as TPG, and JP Morgan

• GP Perspectives from storied investors such as Tomasz Tunguz from TheoryVC

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Identifying Risks In a Dynamic Environment 

Recently, Goldman Sachs Asset Management published their perspectives on how private market investors are behaving throughout current market disruptions.

The report dives into the risks that GPs may face when it comes to their existing portfolio growth, as well as the importance of timing a fund’s capital deployment. 

A few points I wanted to highlight from Goldman’s report:

Risks to Monitor for Existing Investments

According to historic data, challenging macro environments often favor private market investments. Global buyout IRR saw spikes coming out of both the 2001 tech crash along with the 2008 financial crisis. 

That is not to say that private companies are immune from the changing business cycle trends. Specifically in regard to inflation and rising rates, there are two main challenges for PE-owned companies:

1. Operating Margin Pressure 

According to Goldman’s report, 2022 was the first year in which median EBITDA growth failed to keep pace with, or exceed, median revenue growth in over a decade. Portfolio companies are not immune from business cycles as cost pressures and price increases are having direct impacts on customer demand.

1. Cash Flow Pressure 

Rising rates are also having effects on cash flows for companies with significant leverage. Just take a look at the following example:

Given expectations of a higher cost of capital, efficiency and cost discipline will become even more important for portfolio operations in years to come. LPs should consider managers with experienced operating teams that can support growth in a capital-efficient manner.

The Timing of Capital Deployment 

In today’s environment, deals are generally smaller and capital structures are more conservative. Goldman highlights that the average buyout deal, for example, is now using 1.4x less leverage than before.

This has led to buy-and-build strategies becoming more popular due to the lower entry multiples. According to Pitchbook, in Q1 alone, add-ons (defined as acquisitions by companies with PE backing) accounted for ~65% of the total PE deal count. As opposed to larger LBOs, these deals can deliver incremental revenue and EBITDA growth to cover the escalation in interest costs.

However, these types of deals should be marked “buyer beware”. Just because a deal is cheap does not mean it will necessarily be a good investment as a fund may not have the required expertise to help build the company. As an LP investing in a buy-and-build strategy, it’s important to make sure that the fund has the right teams in place to expand a business, not just finance it.

I also expect that deal volume will recover as GP's incentive to deploy dry powder grows. If GPs aren’t deploying capital quickly, they eventually will need to as their funds reach the end of their expected investment period. However, deals executed by funds with high levels of dry powder toward the end of the investment period risk being large, more expensive, and hasty. Goldman’s report notes that these types of funds, typically 3-5 years old, account for almost 40% of PE dry powder today.

How Do We Think Through This

With a challenging macro environment ahead, return dispersion across managers could become even more noticeable. The report notes that dispersion is already increasing for funds whose value is still largely unrealized.

LPs should seek out GPs with a proven ability to create value within their portfolio companies along with experience in deploying capital during turbulent times.

Understanding the experience and makeup of an operating team will be ever important. A cost-disciplined operating approach may be rewarded in a high-interest and inflationary environment.

LPs should be prudent in learning about a fund’s deployment timeline. Misaligned incentives are often at play and can significantly impact a vintage’s return profile.

Seeking the right manager with the right strategy will be even more crucial in years to come. Be sure to consider the track record of the individual managers themselves, their strategy, and the consistency of returns.

If you enjoyed this read and have any questions or would like to discuss further, feel free to schedule a call with us - we’re happy to chat.

Updates from Across the Ecosystem

Fundraising

📈Blackstone targets $10bn for new US direct lending fund

📈 Lux Capital raises a new $1.15bn fund

📈 J.P. Morgan Growth Equity Partners raised its inaugural Growth Equity Fund, with over $1bn in aggregate capital commitments

Reports

🔬The Evolution of Private Market Secondaries

🔬State of Private Markets: Q1 2023

🔬TPG Impact Investing: The Road Ahead

Chart of the Week: Lack of Diversification for HNWs

According to Bain, less than 15% of companies with revenues of more than $100 million are publicly held resulting in a lack of options regarding portfolio diversification. Even if investors hold their positions entirely in a 100% diversified public stock index, they won’t own shares in the over 85% of privately held companies with $100 million of revenue or more. Private equity funds offer investors a way to add this level of diversification to their portfolios.

GP Perspectives

Tomasz Tunguz (GP, TheoryVC)

📖 On the relationship between interest rates and VC activity

Tomasz has done an excellent job in using statistical modeling to predict VC investments and activity using interest rate activity.

With interest rates rising and valuations falling, LPs are becoming more prudent with their capital which translates to fewer venture dollars being invested. It is imperative for LPs to pay attention to macroeconomic factors like interest rates as it becomes increasingly apparent these factors have strong relationships to the performance of early-stage funds.

Harry Stebbings (GP, 20VC)

This speaks to how important it is for LPs to identify which fund managers are able to see the importance, resiliency, and exponentiality of a strong business model. PE & VC funds that take an incisive approach to examine the core of a company’s business model and the growth that could stem from it are the funds that LPs should pay attention to. 

Jason Lemkin (GP, SaaStrFund)

📖 VC market in 2022 versus 2023

In his short but powerful tweet, Jason gives investors a warning that 2023 is nothing like 2022. In fact, 2023 could even be a year of opportunities. Sometimes it’s a fortitude to be patient, however, investors should know when to strike. Waiting out for a market rebound could lead to potential missed opportunities. Although there is still economic uncertainty, investors should start being proactive and consider deploying capital in the right places again.

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