Nearly $120 billion was deployed into the private equity and venture ecosystems in the US through the first three months of 2018. However, as capital invested figures have remained historically high, underpinned by heightened valuations and growing check sizes, volatility in other parts of the markets has perked up. Public equities and the closely watched crypto markets have undergone considerable price swings, all while limited partners have continued to commit substantial capital to PE and VC fund managers—including to first-time GPs branching out on their own. In addition, we've seen some notable shifts in both transaction and corporate structures, as evidenced by Spotify launching the first successful direct public listing, along with Ares' transition from a partnership structure to a C-Corp.
PitchBook's analyst team has published a plethora of notable thematic research covering the changing dynamic of the private markets. I've profiled some of our top ideas and themes of 1Q 2018 below. I hope you find these insights helpful in your practices.
Gaining exposure to emerging crytpo assets
We expect to see a continuation of newly launched crypto-focused funds in both active and passive strategies. While recent price action has forced some of the fledgling vehicles to close shop, the reduction in froth will cause capital allocators to revisit the space. Previous research suggested that investors had generally remained under-allocated to crypto assets on a risk-adjusted basis; from August 2010 to October 2017, bitcoin outperformed US large-cap equities 298% to 14.5% on an annualized basis, while producing a comparable Sharpe ratio. This performance in part led to the creation of vehicles to invest directly in the new ICO fundraising mechanism, alongside—and in some cases replacing—traditional VCs who typically fund new technologies.
A quarter since our initial publish, broad price declines across the entire crypto asset space, alongside regulatory pressures, have placed scrutiny on token-generating events and the funds that back them. Additionally, crypto hedge funds that have held concentrated positions in bitcoin and Ethereum are also under considerable pressure. However, for many seasoned investors on the sidelines, this price decline may have created an opportunity to take a hard look at deploying capital to GPs that have weathered this and previous corrections.
Welcome to the private debt show
Driven by a combination of increased LP interest in alternatives and a myriad of regulatory measures that have limited traditional lenders, private debt funds have experienced considerable growth as of late. Such vehicles raised close to $120 billion in 2017, the most of any year on record and more than 2.5x the 8.1% CAGR of PE buyout vehicles. In particular, direct lending vehicles raised nearly $53 billion during the same period, representing a CAGR of 39.4% since 2009, a year that saw over $3.7 billion raised.
While we see the rise of non-bank lenders as a net positive for borrowers, this proliferation has incentivized lenders to compete on both price and terms. As a result, we've seen an unprecedented level of covenant-lite loans and the use of add-backs to make issuers appear more creditworthy than they might be in reality. Given this increased risk, we could see these fewer protections and lower rates spell lower returns for general debt funds, while simultaneously unlocking opportunities for distressed debt and turnaround vehicles.
Poised for impact
Demand for socially responsible investing has grown considerably in recent years; however, such strategies may not bring about the outcomes some mission-driven investors are seeking. Enter impact investing, a strategy of for-profit, direct investing in companies or investment funds seeking to generate a return while achieving positive social and/or environmental externalities.
In 2017, over $3.4 billion was invested in PE and VC impact funds globally, though more than half of this value was accounted for by TPG Growth's $2 billion Rise Fund. Although it is difficult to forecast what future fundraising will look like, we believe that with trends including (1) notable commitments from LPs such as the Ford Foundation and the Catholic Church, (2) the increasing participation of major alternative asset managers like TPG and Bain Capital, and (3) the presence of over 20 open impact funds targeting $100 million or more, fundraising and subsequent investment activity in the space will proliferate further.
In a sample of 270 impact funds, we saw that 59% of VC funds and 82% of PE vehicles target investments in emerging markets. As more mainstream alternative investors enter the market, we think these funds will likely focus more on investments in developed markets, which offer less economic and political volatility, as well as a pipeline of investible opportunities in sectors like energy, agriculture and transportation that are actively adopting sustainability practices.
A SPOT of secondary activity
In an attention-grabbing move, Spotify recently completed its direct listing into the public markets. The company raised no additional capital, but rather provided an immediate path to liquidity for its shareholders. While the listing certainly didn't come without hiccups, we think the early indications of the company's direct listing experiment was a success. One of the most common worries with the listing revolved around the volatility of initial trading without a lock-up period or formal underwriting support. However, the share price fluctuation of $20, which calculates to a 12% variation from the initial pricing of $165.90, is fairly low volatility for the first day of trading of a technology IPO.
Further, Spotify made a concerted effort to smooth the transition to public markets by promoting increased volume in the private secondary markets over the last few quarters. While these transactions certainly varied widely in terms of price, we believe these sales provided ample price discovery prior to the listing and ultimately contributed to the subdued volume and lower volatility than was previously expected.
A new horizon for PE: contemplating C-corp conversions
Newly enacted US tax legislation has seemingly provided a long-awaited catalyst for the first major publicly traded alternative asset manager to transition from a partnership to a C-Corp. In February, Ares became the first firm to blink and officially announce its conversion, aiming to broaden its investor base, improve its liquidity and trading volume, and garner access to a new acquisition currency, among other items.
The prospect of publicly traded PE firms converting from partnerships to corporate structures has been discussed for years, with the tactic viewed as a solution to the common belief that PE firms’ shares are perpetually undervalued. With the move, these firms would become eligible for indices and gain exposure to new investors by being included in retail products, potentially leading to higher valuations.
However, changing to a corporate structure means that performance-related income will be taxed at the corporate rate before being distributed to shareholders. As such, firms that make the switch will likely resemble Ares, with a relatively higher proportion of management fees compared to performance fees. Given that the decision to convert to a C-Corp is essentially irreversible, as the tax costs and structural complexity are prohibitive, we expect to see most firms adopt a wait-and-see approach to see how the first mover fairs.