Q4 2023 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 refi 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’s 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 recapped with cheaper debt down the line.
• What does this all mean? There’s a decreasing supply for equity, while there’s 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’s a continued bid/ask spread between buyers and sellers on valuation and the challenged credit market makes 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 appropriate for the higher cost of debt and reduced leverage levels, which drives moderating valuations. 
• Remain highly selective and only invest in the highest-conviction opportunities.

Emerging Managers

• With a few notable exceptions, fundraising continues to be prolonged, especially for emerging managers. It should not necessarily be viewed negatively, however, as it provides the opportunity for potential LPs to watch fund development and early stages of portfolio construction come together prior to leaning in for a commitment. Managers are also adjusting target fund sizes to align with the challenging fundraising environment.
• Appetite for lower middle-market exposure is growing amongst institutional LPs of all sizes as there are meaningful alpha generative opportunities available in the small-cap space. This part of the market continues to grow as new managers emerge with less banked deal flow and broken processes. GPs are also building relationships directly with founders, leading to longer courting periods which provide a pipeline of directly accessed deal flow. Selection remains critical, as many of these companies will need significant turnaround and operational kickstarts to fuel growth.
• Emerging manager co-investment opportunities continue to be introduced at a higher pace, serving as an introduction and glimpse into new managers raising capital. Buyout opportunities have dominated in volume, but sector focus has varied and provided us with exposure to various theses and strategies being applied by new managers. We’ve also seen a wide array of different capital structures and creative ways that managers are using to both win and finance their opportunities. With the macro conditions and lending environment seeing little change since last quarter, we expect similar trends to persist as managers pursue both individual deals to validate their strategies and attract new fund capital.   

Fund Investments

Returns

• As everyone is doing a recap on 2023, it's worth reflecting on performance, but alas, with private markets, we still have a lag, so our one-year is LTM from Q3 2023. Returns varied but generally fell below longer-term averages: 
  • All Private Equity – 3.2% annual return vs. a 16.3% annualized 5-year return
  • Buyout – 9.3% annual return vs. a 15.2% annualized 5-year return
  • Growth – 0.5% annual return vs. a 17.9% annualized 5-year return
  • VC – (10.1%) annual return vs. a 17.5% annualized 5-year return
  • Credit – 10.6% annual return vs. a 7.5% annualized 5-year return 
• Clearly, there is still some mark-to-mark pain in VC and Growth, and we expect that may continue for a bit longer, but asset selection is critical. Companies needing cash infusions to offset high burn rates are looking for alternatives to a down round, and they will only be able to kick the can down the road for so long. Expect to see consolidation and a return to profitable growth.
• Credit continues to deliver higher returns as interest rates have increased. It also doesn't hurt that defaults have been more limited than most expectations.
• That said, spreads are coming down in the space, and any distressed manager, what few remain, will tell you defaults are picking up. Our view, though, is that this continues to be a better risk-adjusted return profile for the space than we have seen in a long time. 

Q4 2023 Cashflows

• Q4 tends to be a significant contributor to these numbers. If we look at all PE (Buyout, Growth and VC), Q4, from a capital call perspective, is coming in lower than we expected from talking to GPs.
• Capital calls actually slowed down, and Q4 was the smallest quarter of the calendar year 2023. This is noteworthy, given how rare it is. In the last 29 years, where we have readily available data, it has only happened in 2023, 2008 and 2000. About 70% of the time, Q4 is the largest quarter of capital calls and, by a decent margin, oftentimes accounting for 30% of capital called in the year.
• Distributions told a different story for the year in Q4, as it was the highest quarter and represented 32% of all distributions in 2023.

Annual Cashflows

• The problem for distributions is that in both absolute and relative terms, they remain down compared to the highs of 2021 and historical norms (at least compared to NAV). In dollar terms, distributions for 2023 are in line with 2020 or 2019 but are only 42% of 2021 levels. When you adjust for the growth of the asset class, (NAV) distributions are behind as long-term averages tend to be between the 20% and 25% range. For 2023, distributions were only approximately 11.1% of NAV.
• Capital calls are also slower on a relative basis but haven't decreased as much as distributions. In an average year, you might expect about 40% of your unfunded to be called; in 2023, that was approximately 32.5%.
• More anecdotally, we continue to see a gap between seller and buyer expectations, leading to fewer deals crossing the finish line and typically only higher-quality companies trading. It also means that GPs are looking at their DPIs and looking for ways to enhance them. Expect chatter on NAV loans and continuation vehicles to go into overdrive if things don't improve on the distribution front in the next few quarters.

Fundraising

• Speaking of fundraising, it's still tough. Slower, smaller and stalling new fund launches when you can sum it up. One and done isn't a thing; hitting a target fund size means a job well done.

Impact

Deal flow:

• Impact deal flow continues to thrive, as we are seeing 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 the 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 (IEA), 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 macro/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’d 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 2Q, with the pendulum turning in favor of buyers. Deal activity has slowed in Q4 2023, but we anticipate it will pick back up in early 2024.

Real Estate

• Despite capital markets volatility in 2023, most commercial real estate asset classes continue to show strong fundamentals (office is the exception). Multifamily and industrial real estate remain the favored sectors given structural demand tailwinds, low vacancy rates and continued rent growth across most markets.
• As lending standards tightened and the cost of debt increased sharply in 2023, obtaining accretive debt became more difficult. The lack of available financing in the market has helped to keep new supply muted, allowing for tenant absorption in sectors that had a run up in new construction activity.
• Transaction activity has begun to increase slightly with cap rates expanding on average 100bps to 200bps depending on the asset class.
• We expect 2024 to be an attractive vintage for commercial real estate investments given higher entry yields and strong underlying property fundamentals.
  

Secondaries

Venture Capital & Growth

Venture Capital

• Early-stage rounds remain competitive, while later-stage activity at the end of 2023 stabilized at historically low levels.
• Venture managers deployed capital cautiously in 2023 as the number of new deals announced remained low consistently low throughout the year.
• Many late-stage companies successfully cut their cash burns and stayed out of the market in 2023 to avoid down-rounds while they grow into their previously set valuations.
• Demand for artificial intelligence companies across stages continues to command premium valuations as businesses across all industries look to define their own AI strategies.
• Artificial intelligence startups continue to command premium interest and valuations as the technology continues to expand and businesses across all industries focus more on defining their own AI strategy.

Growth

• Deal activity in growth equity remains low as companies cut their burns and protected their cash balances to extend runway.
• Pricing on growth rounds has come down to historical norms across sectors, with the exception of AI, which has shown valuation resilience.

Other Observations

• GP fundraising is expected to pick up in 2024 after a slow 2023 with several mangers signaling their plans and opening data rooms at the beginning of the year.
• IPO exit activity may remain subdued in the near term as some recent tech-IPOs in late 2023 had poor starts.
• VC/Growth secondary volume remains strong across LP-led and GP-led deals as sellers look to create liquidity and the bid/ask spread continues to narrow.