PE Hub: Private Equity Will Separate Into Winners and Losers

'This next year or two will be interesting as there could well be an industry shakeout for the first time since the dot-com bubble exploded in 2000.'

By Mary Kathleen Flynn, PE Hub

Hartley Rogers joined Hamilton Lane 20 years ago in 2003 and has served as chairman of the board since 2005. Prior to joining the Conshohocken, Pennsylvania based private markets investment firm, Rogers was a managing director in the private equity fund management areas at Morgan Stanley and Credit Suisse. On January 1, 2024, Mario Giannini – who has been the CEO of Hamilton Lane for 22 years – joined Rogers as executive cochairman, as long-time executives Erik Hirsch and Juan Delgado-Moreira have begun serving as co-CEOs.

Hamilton Lane is one of the largest private markets investment firms globally, with $854 billion in assets under management and supervision as of September 30, 2023. The firm says it provides innovative solutions to institutional and private wealth investors around the world and has been dedicated to private asset allocations for over three decades, employing nearly 700 professionals globally. The firm uses an investment toolkit for itself and its clients anchored by a proprietary software system called Cobalt LP.

PE Hub asked Rogers to share his insights on a wide range of topics, including how private equity holds up against the public markets and why he thinks the PE industry may be on the verge of a shakeout.

Our interview with Rogers is part of PE Hub’s ongoing series of Q&As with private equity thought leaders.

PE Hub (PEH): How has private equity performance compared with public market performance over the last 10, 20, 30, 40 years? How did PE perform in past periods of economic decline, like the dot-com bubble burst and the global financial crisis?

Hartley Rogers (HR): Private equity has outperformed the public markets almost every year on a public market equivalence basis, and it also outperformed on a rolling 10-year basis much of the time.

We have data to show the public market equivalence performance of private equity compared to public market benchmark in each vintage year (private market metrics applied to public market) as well as time-weighted returns (public market metrics applied to private markets).

In brief, that data historically shows there is substantial outperformance of the private markets over time. During the dotcom and GFC eras, public market declines continued well past three quarters, and they have rebounded sharply over the last two quarters.

PEH: Hamilton Lane’s analysis shows that private equity’s outperformance of public markets tends to be at its greatest level during periods of mediocre or negative public market returns. Why?

HR: This has more to do with the volatility in the public markets than the private markets themselves. When public markets are strong, private equity’s outperformance is lower. In any other environment, it’s higher. This is because private equity tends to be conservative in its valuation practices. If the public markets are going up, private market GPs don’t want to create false expectations – since what comes up can come down – so they want to make sure there’s conservatism and a cushion in what they’re presenting as valuations.

So, the data shows private market valuations don’t increase as quickly as public market valuations during those times. Conversely, private market valuations don’t come down as much as public market valuations when there’s a big falloff, as what happened in early 2022. When the Fed started raising interest rates, everybody was very focused on private market valuations and they didn’t go as fast or as far as the public markets.

There are a number of good reasons for that, but it really comes down to the “ends” – when public markets are way up, private markets don’t react as quickly, and when public markets are down, there’s some cushion in the private markets. Ultimately, private markets tend to be conservative anyway.

PEH: How are valuations being affected by the current economy, including high interest rates? Are buyers and sellers still at odds with respect to valuations?

HR: This has as much to do with activity as much as it has to do with the valuations.

Any time that you have a change in underlying financial conditions, it takes a while for people to come to terms with the new normal – the bid-ask spread is either expanding or narrowing. High interest rates mean a higher cost of capital, which means lower valuations. Today, we’re seeing valuations coming down, and sellers are getting used to the new normal.

PEH: What can you tell us about returns for deals getting done now?

HR: The returns we look at have to be higher because interest rates are higher. GPshave to believe returns are going to be better, but I can’t say what they are –that depends on the deal and the industry.

PEH: What exit strategies are effective and/or which kinds of PE-backed companies can exit today and which can’t?

HR: Good companies will always find exits because there are always investors who want to hold them. Traditionally, IPOs have been an effective exit strategy; however, the IPO market has been under pressure so they’re somewhat less effective today. Yet, we’ve seen plenty of companies do well with private investment and know there will always be strategic and other financial buyers interested.

Continuation funds can be a viable option for all parties – but they’re not always a good idea. If a GP is willing to bet on that investment, it might work. But, you have to have the moon, stars and planets align to ensure these deals happen. It’s a viable strategy, and one we utilize for a number of interesting opportunities, but it’s not always the best strategy.

PEH: What will it take for deal activity to pick up again, and when might this happen?

HR: We live in an uncertain time right now, and there are many elements causing this uncertainty: geopolitics, the US election, the US economy and the cost of funding the government are just a few. Elements of uncertainty don’t shut down deal activity, but they do give investors many more factors to consider when evaluating deals and generally push folks towards lower pricing than in an environment that is comfortable and predictable.

Stability and predictability are important for deal activity. We’re likely in for lower deal activity for another nine to 12 months because of this general instability. On the other hand, as time goes on, people will get used to the new normal in terms of pricing, and sellers will get comfortable with accepting values that are lower than what those businesses would have commanded years ago. So it’s really about getting used to the new normal.

PE Hub: Why do you think PE performance will continue to beat public market performance in the future, even if we see a sustained period of higher interest rates?

HR: We believe private market performance will continue to outperform public market performance, primarily because of a few key factors: governance and alignment of interests. Boards are composed in a particular way to align interests with the management team and maximize business value. There are no quarterly earnings calls, so the management team is empowered to look out a bit further and make investments they believe will pay off for the business in the medium- and long-term instead of just focusing on shorter-term operations.

PEH: What opportunities does a tough environment like this open up?

HR: In a difficult fundraising environment like the one we’re in now, GPs have to look to non-traditional sources of funding. We expect to see a bit of a shakeout in the next 12-18 months. The market will separate into winners and losers, and the industry will divide itself into different segments – offering their own risk-reward profile rather than what’s traditionally been the private equity makeup. This next year or two will be interesting as there could well be an industry shakeout for the first time since the dot-com bubble exploded in 2000.