What Are LPs Talking About?
Turn to the Market
Most of us arrive at the start of a new year with a sense of anticipation, excitement and hope for what’s in store. And this year is no exception. After all, 2022 has a lot in store for us: The Winter Olympics, The Queen’s Platinum Jubilee, a new Taylor Swift re-recording, the second season of Squid Game. But it’s also fair to say that this year – as investors – we need to add just a bit of anxiety to the emotional mix as well. New and growing headwinds around inflation, interest rates, volatility, oh my!
While not quite as intriguing as anything Squid Game or ‘Swiftie’-related, at Hamilton Lane, we are also looking forward to exploring these topics and more in our annual Market Overview. Consistent with previous movie-themed articles we wanted to provide a trailer of sorts ahead of the Market Overview presentation (coming to a screen near you on February 24!). Consider this piece a precursor to that event, where we will take a more comprehensive view of themes, trends and activity for all things private markets. And just like our signature Market Overview, in this preview we will endeavor to provide unique data and valuable insights – albeit on a smaller scale. If you’ve ever read a full Market Overview book, you know what we mean.
Specifically, we thought we would explore a few of the big topics that LPs can’t stop talking about, woven together with and supported by a few pieces of our proprietary data.
Aside from the more recent focus on inflation and interest rates, there were two undeniable winners as the most discussed topics within investor portfolios – pricing and performance. With a side of benchmarking.
Pricing. We’ll cut to the chase here: Prices are high in the private markets. Is this concerning? Sort of – see the chart below. This is certainly something to keep an eye on, especially if one considers it a sign of a ‘market top.’
Buyout Purchase Prices
EV/EBITDA and % Equity, Median by Deal Year
Now for some perspective: Prices are expensive everywhere – public markets, gas stations, grocery stores. In the private markets this is a trend that began about a decade ago and has continued. Today, the private markets multiples are at or above all-time highs. And while they remain below public market multiples and have relatively high equity cushions, the pricing in private markets is major.
Pricing, however, is just one factor in the dynamic of private markets investing. Remember, the basic premise of the private markets is 1) buy, 2) enhance/grow/improve/fix, and 3) ultimately sell private companies. The private markets operate in that sweet spot between buy and sell, by using time and the general partner’s ability and expertise to create upside value. Clearly, while the price at which a company is purchased plays a significant role in the investing equation, it is not the sole determinate of the outcome.
Lastly, let’s not forget the active, control-oriented investment strategy of private investing versus a more passive public market context. That is generally why GPs in the private sphere can better "control their own destiny" with ultimate investment outcomes.
Want evidence? The chart below shows some of the techniques that the general partners utilize in executing their value creation theses to generate returns. As you can see, the private markets aren’t solely reliant on selling assets at higher prices (buy low, sell higher) in the future to generate returns. In fact, the data below shows that the vast majority of investment returns are driven by earnings growth.
Value Creation Drivers for Unrealized Deals
By Deal Vintage
With that as a backdrop, we’ll acknowledge that while investors ask about pricing, we suspect that their primary focus is, and should be, around performance. After all, performance is the overwhelming reason investors allocate to the private markets. And the private markets have delivered.
We looked at the impact of investing a dollar in 2017 across the private and public markets. You see the results here.
Growth of $1
Impressive. In the private markets, we’re long-term investors, so we tend to focus on outcomes over longer time periods. So, what if we were to zoom out over the last two decades? Same result. In the last 20 years, the pooled average (note the emphasis) private equity buyout and private debt funds have outperformed their public market alternatives in EACH and EVERY vintage. And, they’ve done so by significant margins – to the tune of over 1,000 basis points for equity; and over 600 basis points for credit. Undeniable. And those margins increase if you manage to invest better than average.
- It’s important to contextualize (fancy word for benchmark) this performance. Here are the stats on buyout returns from our data scientists: The median performance for the 2016 through 2020 vintages are competing with the top quartile returns seen earlier in the decade. Said differently, today’s median performance is higher than the best 10 years ago. And 10 years ago was a good time to invest.
- If you were to rank the top-quartile threshold for each vintage year in Hamilton Lane’s data set from 1982 to 2020, the most recent five years would be ranked 1, 2, 3, 4 and then 8 for 2020 through 2016 respectively. What’s the moral of this tale? Even deals done in that high-priced environment have resulted in the best performance in the industry.
Here we have to acknowledge one of the key challenges the above benchmarking data creates for private market investors. In a period where median performance for the asset class has been so good – and has been coupled with a healthy dose of distribution activity, to boot – how do investors make selections regarding which funds and managers to support as they come back to market? That is a much larger topic to be discussed another day.
And finally, a reminder that it’s all relative…Not only the ability to dictate outcomes from active management, but purely on a "statistical” basis, current performance of the public markets is close to its historical high. While private market returns are also elevated above historical median levels, they are not nearly to the extent of what we have seen in the public realm.
If you are a believer in a ‘reversion to the mean,’ it is hard to argue that the public markets won’t have more downside exposure going forward.
% of Private Equity Funds Outperforming PME
By Vintage Year
So, these are a couple of the most common questions we’re hearing from LPs – but the truth is, we’ve barely scratched the surface on the level of data, analysis and insightful commentary we have to share. To that end, please stay tuned for the 2022 Hamilton Lane Market Overview, because there is plenty more in store come February.
Corporate Finance/Buyout: Any PM fund that generally takes control position by buying a company.
Credit: This strategy focuses on providing debt capital.
Private Equity: A broad term used to describe any fund that offers equity capital to private companies.
Real Estate: Any closed-end fund that primarily invests in non-core real estate, excluding separate accounts and joint ventures.
MSCI Europe Index: The MSCI Europe Index tracks large and mid-cap equity performance across 15 developed market countries in Europe.
MSCI World Index: The MSCI World Index tracks large and mid-cap equity performance in developed market countries.
S&P 500 Index: The S&P 500 Index tracks 500 largest companies based on market capitalization of companies listed on NYSE or NASDAQ.
PME (Public Market Equivalent): Calculated by taking the fund cash flows and investing them in a relevant index. The fund cash flows are pooled such that capital calls are simulated as index share purchases and distributions as index share sales. Contributions are scaled by a factor such that the ending portfolio balance is equal to the private equity net asset value (equal ending exposures for both portfolios). This seeks to prevent shorting of the public market equivalent portfolio. Distributions are not scaled by this factor. The IRR is calculated based on these adjusted cash flows.
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Certain of the performance results included herein do not reflect the deduction of any applicable advisory or management fees, since it is not possible to allocate such fees accurately in a vintage year presentation or in a composite measured at different points in time. A client’s rate of return will be reduced by any applicable advisory or management fees, carried interest and any expenses incurred. Hamilton Lane’s fees are described in Part 2 of our Form ADV, a copy of which is available upon request.
The following hypothetical example illustrates the effect of fees on earned returns for both separate accounts and fund-of funds investment vehicles. The example is solely for illustration purposes and is not intended as a guarantee or prediction of the actual returns that would be earned by similar investment vehicles having comparable features. The example is as follows: The hypothetical separate account or fund-of-funds consisted of $100 million in commitments with a fee structure of 1.0% on committed capital during the first four years of the term of the investment and then declining by 10% per year thereafter for the 12-year life of the account. The commitments were made during the first three years in relatively equal increments and the assumption of returns was based on cash flow assumptions derived from a historical database of actual private equity cash flows. Hamilton Lane modeled the impact of fees on four different return streams over a 12- year time period. In these examples, the effect of the fees reduced returns by approximately 2%. This does not include performance fees, since the performance of the account would determine the effect such fees would have on returns. Expenses also vary based on the particular investment vehicle and, therefore, were not included in this hypothetical example. Both performance fees and expenses would further decrease the return. Hamilton Lane (UK) Limited is a wholly-owned subsidiary of Hamilton Lane Advisors, L.L.C.
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The calculations contained in this document are made by Hamilton Lane based on information provided by the general partner (e.g. cash flows and valuations), and have not been prepared, reviewed or approved by the general partners.
As of January 27, 2022