Q1 2024 Private Markets Investment Briefs

Direct Credit

• Elevated interest rates and depressed primary leveraged loan issuance (largely by the banks) continue to be tailwinds for the private credit market.
• Our credit deal flow continues to be at record levels, with ~$11.7B through the end of November 2023 (vs. ~$8B in all of 2022).
• Anecdotally, we are seeing less sponsor-to-sponsor new deal activity and more add-on/growth in existing platforms as well as refinancing activity.

• The loan distress ratio is <5% while the LTM default rate is below 2%.

• Goldman recently launched a very bullish report on the direct lending/private credit sector, noting expectations for growth stemming from (i) LP underallocation, (ii) a shift away from active liquid/HY allocation and (iii) attractive returns.

Direct Equity

Supply/Demand Dynamics

• We continue to find ourselves in a favorable supply market as a co-investor.
• What is accounting for that discrepancy between what we’re seeing in the market broadly, which is largely a pullback in fundraising and increased CI volume?
  • GPs are still looking to get deals done with fewer traditional capital sources available to them, compounded with a more challenging lending environment.
  • Deals need to be over-equitized in hopes of getting recapitalized with cheaper debt down the line.
• What does this all mean? There is a decreasing supply for equity, while there is an increasing demand for it.

Deal Flow  

• Hamilton Lane, as a large, institutional co-investor, is positioned very favorably given the supply/demand dynamics.
• Our 2023 deal flow is on track to outpace last year’s deal flow by more than 20%, and 2022 was a record year.
• In terms of size profile, we’re seeing more deals that are small (add-ons that are easier to digest and finance) and huge deals (take-privates, particularly in tech) due to the pullback in the public markets.

Exit Activity

• Exit activity remains muted and the IPO market has remained effectively closed for the last 15 months.
• Precedent shows that no period of subdued IPO activity in the last 25 years has lasted longer than 18 months.
• There is a pipeline of potential issuances ready for when the market re-opens, but there are clear divergences by sector, with clean energy having the most investor demand and consumer discretionary having the least.
• GPs are holding onto companies for longer or looking to acquire companies that they previously owned. In uncertain environments, GPs are more comfortable sticking with familiar assets.
• There is a continued bid/ask spread between buyers and sellers on valuation, with the challenged credit market making it tough to get deals done.

Our Approach  

• Invest in sectors that are resilient, and products and services that are mission critical. 
• High earnings and asset quality are paramount. 
• Align deals alongside GPs with sector expertise to invest through cycles.
• Price equity returns at levels that are appropriate for the higher cost of debt and reduced leverage levels to drive moderating valuations.
• Remain highly selective and only invest in the highest-conviction opportunities.

Emerging Managers

• The emerging manager landscape continues to provide a large opportunity set. Year to date, 2024 has already presented close to 40% of prior-year emerging manager opportunities. We are ahead of the pace in opportunities received and have met with about 45% of submitted funds.
• Emerging manager co-investment opportunities continue to be introduced at a steady pace, serving as an introduction and glimpse into new managers raising capital. While these groups are seeing more opportunities there has also been a noticeable mix in quality requiring deeper diligence to evaluate relative value. However, due to the macroeconomic conditions, combined with continued uncertainty around the lending environment, we have noticed opportunities being priced at lower and attractive valuations. These deep value assets are being pursued by emerging managers and established players alike. Thus, we continue to see a wide array of capital structures and creative approaches by managers in winning opportunities away from larger and longer established sponsors. We expect similar trends to persist in the near term.
• GP seeding and staking continues to gain traction throughout the emerging manager market, as GPs are facing extended fundraising outlooks. Stakers continue to court a new cohort of emerging GPs with working capital and large LP commitments for management company ownership, as well as participation in their economics. While these arrangements can be beneficial for the GP to raise capital, they often come at the expense of convincing other LPs that the manager is focused on long-term growth and alignment.  

Fund Investments

GP Deal Flow

• GPs continue to expect that deal flow will bounce back this year. Bankers are eager to complete transitions, but valuations will be down a bit from 2023 expectations.
• A couple of value-oriented GPs have noted a frothier environment for carve-outs as larger businesses are trying to become more efficient and looking to divest certain assets.
• Credit GPs are seeing opportunities primarily in M&A transaction; spreads have compressed at the top of the market and the mid-market is seeing some compression while there are still wider spreads in the lower end of the market.

HL Deal Flow

• We continue to speak with new managers, and while GPs didn’t necessarily require a placement agent from 2020 to early 2022 to build their books, we see opportunities coming in from our relationships with intermediaries, even for funds with strong performance in prior funds. GPs who have historically not used placement agents have also hired agents to help finish up fundraises or expand geographic LP footprints.
• Seasoned primaries with an immediate J-curve pop, or still-early-but-visible portfolios that decrease blind pool risk, continue to be a focus as managers who have been investing for 12-18 months are trying to wrap up their fundraises in Q1/Q2.

Fundraising

• Fundraising continues to be slower for many managers. Some funds that had a first close in 2022 are now finally having a final close, creating the opportunity noted above.
• This hasn’t stopped funds from launching; we continue to schedule site visits this spring for funds that are seeking summer or fall closings, albeit with a trend towards more realistic target sizes.
• GPs that may have struggled a bit to get their first close but ultimately got there are now starting to feel some momentum, which may translate to targets being hit after all.

Impact

HL Deal Flow:

• Impact deal flow continues to thrive, as we see a record number of direct impact transactions available to our platform throughout 2023. Our deal flow sourcing engine is working well; we’re seeing deals from sponsors as well as directly from businesses and advisors.
• We are also on pace to screen a record number of self-identified impact funds, despite the expectation of a broader capital-constrained market. We are currently on pace to see >30% more funds in 2023 than seen in 2022’s record numbers.

Market and Macro:

• In September, the European Commission published consultations to assess enhancements to the SFDR regulation, noting the fact that SFDR has been largely applied as a labeling system to date, with often inconsistent interpretations of the law.
• In the U.S., anti-ESG legislation has been proposed across 37 states, of which 17 states have enacted some form of this legislation, largely focused on public market investing.
• In Japan, the Prime Minister has announced intentions to direct a substantial amount of the country’s savings towards sustainable investing.
• Renewable energy sources, in combination with nuclear power, will more than cover the increase in global electricity demand from 2022 to 2025, according to the International Energy Agency, further supporting tailwinds in key impact investment themes.
  

Infrastructure

• Global transaction activity has continued its slow pace with just shy of 300 deals completed in Q3 2023, a 31% decline YoY, noting that 2022 was a record year for the industry.
• Telecom and renewable energy continue to lead the league tables with investors maintaining a positive, long-term view on the tailwinds driving both sectors.
• There was a flurry of fundraising activity in Q4 as several large-cap funds held closes at or above their target size, however capital remains scarce, which is amplifying the value of the HL platform as evidenced by the YoY increase in CI flow across the group.
• Despite rising rates, inflation and macroeconomic/geopolitical uncertainty, private infrastructure continues to deliver on its value proposition of generating stable and predictable cash flows through essential high barrier-to-entry assets.
• Our infrastructure team sees a robust and attractive opportunity to invest across sectors, geographies and investment types. Buyer beware, however, as sector specialization and a multi-dimensional framework for assessing risk is vital to achieving desired outcomes. Recent examples substantiating this include bets on the UK water sector (environmental/regulatory risk), PJM capacity markets (market structure), midstream acreage dedications (volume risk), and contracted power assets adversely impacted by winter storm Uri (via basis risk).

Key updates across select infrastructure sectors include the following: 

• Digital infrastructure: Despite the market for data centers adjusting to rising rates following a period of exuberant purchase prices and free-flowing credit, a day of reckoning appears to have been avoided, for the most part, at least as it pertains to hyperscale-oriented platforms, as eye-watering levels of computing demand from hyperscalers and restrained supply have fundamentally shifted the outlook relative to 12 months ago. Despite favorable long-term demand trends, selectivity is key in accessing fiber and tower assets, with mixed results observed within the fiber-to-the-home segment of late, as rosy uptake assumptions fail to materialize as budgeted for some investors.
• Energy/Power: There are robust and dynamic opportunities to invest across the energy value chain as energy security and decarbonization objectives necessitate massive capital investments, which governments have been keen to incentivize. Expect energy markets to remain complex and volatile amid a sea of change, including changing sentiment around what constitutes ‘clean’ energy and resources needed to facilitate the energy transition.
• Transportation: Zigging and zagging is how we would describe fundamentals within the transportation sector. The post-COVID trade boom has ended, as evidenced by container trade volumes and various freight rate indices normalizing, weighing on logistics infrastructure utilization/volumes. On the other hand, global passenger aviation has rebounded to 97% of pre-COVID levels on an RPK basis, up 30% relative to 2022, per IATA’s most recently published figures.
• Secondaries: The long-dated and predictable nature of infrastructure makes the asset class particularly well-suited for secondaries, as we are fielding record infrastructure secondary volume at the top of the funnel. Despite several new entrants in the market, supply has meaningfully outweighed dry powder in recent months, as select buyers temper activity after acquiring sizeable portfolios in H1’23. As a result, we’ve seen pricing come down by ~5% post-Q2, with the pendulum swinging in favor of buyers. Deal activity has slowed in Q4 2023, but we anticipate it will pick back up in early 2024.

Real Estate

• After two years of relatively low transaction volumes, investor sentiment is becoming increasingly bullish in 2024. Many investors, sitting on dry powder, are looking to deploy in today’s attractive valuation environment with entry cap rates 150-200bps wider, on average, than the peak in early 2022.
• The real estate financing environment remains challenging. Interest rates are still high (all-in between 5.5% and 6.5%) and advance rates are tempered. With a wall of maturities coming due in 2024 and 2025, borrowers are in need of refinancing and liquidity solutions across the capital stack. This creates opportunities to acquire or step into high-quality assets at attractive entry points.
• Reduced debt availability has caused construction activity to plummet, which supports the health of the sector’s underlying fundamentals. Total construction starts have dropped 67% from their 2022 peak.
• Given the rapidly evolving and somewhat nuanced real estate environment, we believe compelling opportunities will emerge in 2024 across high-quality assets with strong fundamentals.
  

Secondaries

Venture Capital & Growth

Venture Deployment and Fundraising

• Venture managers remained cautious during Q1 2024, maintaining an investment pace similar to the slower deal-making trend observed throughout 2023.
• VC dry powder started to decline for the first time in this cycle in Q3 2023, applying growing pressure on VC managers to put plans in place for their next fundraise. Several blue-chip firms have initiated or announced their fundraise plans for this year.

AI Dominance

• AI continues to be the dominant investment category amongst venture firms as founders continue to rapidly expand the AI stack with new innovative technologies.

Valuations

• Pre-money valuations on priced venture rounds came up in Q1 2024 at varying levels across stages. Notably, AI represents a growing portion of new rounds where valuations are competitive.

Growth

• The funding environment remains slow for later-stage rounds as companies focus on extending runway.
• Q1 2024 did see an increase in the median pre-money valuations for reported rounds in the later stage; however, the numbers are more likely a signal of survivorship bias where only the highest quality assets are going out to market.

Secondaries

• Volume for LP- and GP-led VC secondaries remains consistently strong with tailwinds going into 2024.
• LPs remain focused on DPI and with low distributions and declining dry powder, GPs continue to utilize the secondary market for creative ways to create liquidity for investors ahead of their next fundraise.