Michael Rebagliati July 30, 2014
Jay Rose, a member of StepStone Group’s board of directors and the firm’s Executive and Investment Committees, took some time to discuss U.S. fundraising with us as part of the release of our 2H 2014 Fundraising and Overhang Report, which publishes Thursday. Topics include PE fundraising, the funds-of-funds landscape, and StepStone’s first Brazilian office, which opened earlier this year. Be on the lookout in tomorrow’s newsletter for the report, which will also be available for download in PitchBook’s report library.
Q: Private equity has more money than it can spend right now, about a half trillion dollars in dry powder in U.S.-based funds alone. At the same time, investors have shunned headline-grabbing buyouts in the $10 billion – $30 billion range. How do you see that dynamic playing out over the next few years, particularly if valuations stay high and investors remain cautious?
A: Though long-term investors should always remain steadfast across different market and interest rate cycles, there are several structural components to today’s market that should put the headline capital overhang number in perspective. First and foremost, private equity firms have had more capital available to them for the last two decades than they could prudently invest. These significant capital flows into private equity are the result of institutional investors seeking higher risk-adjusted returns by exploiting inefficiencies in the private markets. As long as this arbitrage opportunity exists, there will continue to be capital overhang in the asset class. Second, dry-powder has historically ranged between four and five years of deal volume. The current capital overhang falls within this historical range. Third, the relatively low annual fundraising amounts following the global financial crisis have resulted in a younger capital overhang. As such, general partners are not under time pressure today to deploy capital like they were over the last few years due to record fundraising amounts in 2006, 2007, and 2008. Finally, it is important to recognize that general partners are paid management fees on committed capital, not invested, and therefore are held accountable for the timing of capital deployment over the five year investment periods. According to a recent Bain study, approximately $427 billion of the overhang coincides with buyout funds raised since 2011 that have plenty of time to diligently – and patiently – deploy capital.
CalPERS recently stated its disappointment in the FoF asset class and has clearly been reducing its exposure to funds-of-funds over the last 4 years. Given this negative sentiment, as well as the increasing in-house expertise of many larger pensions, do you think funds-of-funds will decline as an asset class in the near future?
Due to their size, CalPERS has a unique challenge deploying capital in the private equity asset class that cannot easily be linked to other investors in the space. However, their experience has been an indicator of both what works and what has changed in the fund-of-funds space. Smaller investors use fund-of-funds to gain exposure to a particular region, strategy, or investment type which they cannot commercially achieve independently. As these smaller investors in the asset class are limited in their ability to either staff internally or gain access to a broad funnel of global investment opportunities, the fund-of-funds model will continue to exist for such investors.
Many traditional generalist fund-of-funds have observed large global LPs shift away from commingled pools to targeted or niche separate account vehicles. These LPs recognize the importance of customized solutions that are tailored to specific investment objectives which cannot be met through a general one size fits all fund-of-funds. Founded as an investment platform to provide these niche solutions to LPs, StepStone continues to see an increase in demand for these services.
In 2012, your firm acquired Parish Capital, a fund-of-fund manager known for its expertise in small, niche-focused private equity funds. Do you see a viable future for these smaller, specialized funds? Or do you expect these smaller funds to struggle with generating deal flow in the future as mega-funds regain their traction in the fundraising market?
We continue to believe smaller, niche-focused funds represent a highly attractive area of the private equity market that can provide LPs potential for meaningful outperformance. Investors have historically benefited from exposure to this segment based on its less efficient nature relative to the larger end of the buyout market (e.g., high number of target companies, relative lack of capital in this space, less efficient coverage by intermediaries), as well as the favorable exit environment made available by the well-funded large cap space. In addition, smaller funds generally provide LPs with attractive alignment dynamics as the economics for the managers of these funds tend to be oriented more towards carried interest than management fees.
These dynamics are very much at play today, and we have seen a growing appetite from our client base for exposure to this segment. However, the risk at the small end of the market is the much wider dispersion of returns compared to the mid and large cap segments. Whereas many LPs historically turned to fund-of-funds such as Parish Capital for help navigating this risk, investors have been moving away from the fund-of-funds model due to their double layer of fees, carry, and inflexible structures. As a consequence, we see a very robust fundraising market for smaller, niche funds, but one that is in transition as managers raise capital increasingly on a direct basis from LPs as opposed to through fund-of-funds.
StepStone emphasizes the importance of specialization in approaching investments, which is the direction many LPs seem to be going these days, sometimes shunning bread-and-butter buyout funds. Do you see this as a new, permanent approach to LP investments going forward?
As the private equity asset class continues to mature, we believe more specialized or focused funds will provide superior risk-adjusted-returns relative to undifferentiated generalist funds. As such, StepStone organizes its research team by sector, strategy, and geography to provide deeper coverage of these more specialized managers in local markets. We believe LPs recognize the importance of specialization in a more competitive global marketplace. As such, managers with a unique value proposition who have demonstrated clear outperformance will continue to experience shorter fundraising cycles as a result of significant LP demand.
StepStone opened its first Brazilian office earlier this year. What factors do you see as driving the development of a more mature secondaries market in Brazil?
The Brazilian private equity industry was born in the mid 90’s whereas the rest of the region did not get significant traction until the mid 2000’s. As a result, most of the secondary investment opportunities tend to be seasoned tail-end funds or restructuring opportunities concentrated around Brazilian, and some early regional, funds.
Due to the relative size of its economy, Brazil has attracted a significant majority of the Latin America private equity funding over the last 10 years. In particular, 2011 saw record fundraising in Latin America at over $11 billion of which approximately 70% was targeted for Brazil. Increased fundraising amounts combined with the passage of time and the general slowdown of the region will drive future secondary opportunities. Additionally, as local investors in Brazil and throughout the broader region reach their target allocations to the asset class, there will be natural attrition as investors seek to prune non-core managers.
StepStone has also had a big year in its real assets operations – adding 3 senior executives at the start of the year. What are some of your biggest opportunities in this space? Are certain types of limited partners seeking to exit or acquire real asset fund stakes on the secondaries market?
In light of the increasing competition for large scale, core infrastructure projects, StepStone focuses on the lower middle-market space. Examples include strategies involving the acquisition of smaller utilities or power generation assets requiring equity of $50 million to $150 million. Such opportunities usually fall below the radar of investors seeking to write larger checks, and may be acquired through strategic sales or other proprietary processes. Additionally, these assets can later be exited to larger investors looking for diversification and scale.
We also continue to see compelling opportunities for investment in the agriculture sector. Strong macro drivers, such as increasing global demand for food, as well as changing dietary preferences tied to middle class growth, continue to create investment opportunities for investment in the agriculture sector. The opportunity set ranges from lower risk farmland investment and operation strategies, to those focused on providing expansion capital to food and agribusiness sectors.
We are also seeing increasing activity in the secondary market, particularly with respect to infrastructure. In addition to traditional processes driven by asset allocation or funding decisions, infrastructure LPs have been responding to the growing appetite for seasoned portfolios of cash yielding assets by selling their stakes on the secondary market. The combination of relatively limited supply and increased demand has resulted in pricing that is near or at par.
We also recently formed StepStone Real Estate through the addition of the Clairvue Capital Partners team, who have been active investors in real estate secondaries, recapitalizations and co-investments over the past decade. Dev Subhash also joined the group to focus on primary fund investing.
After a period of deep distress in the global real estate markets, liquidity has returned and valuations have normalized. Investors are demonstrating an increasing appetite for risk due to the extreme compression of yields for core assets and gateway markets. As vacancy declines and rents improve, opportunities are emerging to renovate properties that have been undercapitalized, improving positioning and rent levels. New development projects are underway in many markets where values now exceed replacement costs. With the shift in environment, investors are repositioning their portfolios and strategies, resulting in a significant increase in the volume of real estate secondary transactions, both in funds and individual joint ventures. While distressed assets are no longer in abundant supply, an elevated level of loan maturities continue to give rise to recapitalization opportunities, whereby equity gaps are filled to enable refinancing.
Fund raising remains challenging for all but the most established and experienced managers, or those with truly niche strategies. For the balance of the market, smaller fund sizes and prolonged fund raising periods are giving rise to unique co-investment opportunities for LPs with the resources to evaluate direct investments.
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