We’re reviewing activity within the private markets landscape over the last quarter, highlighting the latest themes and evolving trends within a variety of sectors and strategies – all in just a couple of bullet points.
- Private credit yields remain attractive as 3-month SOFR is at ~500 basis points. In simple terms, a first lien deal priced at S+600 is yielding +/- 11%.
- Private credit continues to benefit from the dislocation in the bank market as borrowers demand certainty of financing. The volatility of SVB/First Republic has meant additional tailwinds in favor of private credit vs. bank solutions.
- The market remains relatively bifurcated, with most solutions being either senior/unitranche or contractual return preferred equity. There is very little 2L/mezzanine activity.
- While leveraged loan and M&A activity are expected to be somewhat muted in 2023, HL deal flow remains robust. Through mid-April 2023 deal count is double 2022 levels, with deal $ volume more than double.
- The market remains cautious on interest rate and inflation guidance, continuing the favorable dynamic for strong risk-adjusted returns in the private credit space.
- There has been a pickup in deal flow quality across the size and strategy spectrum within recent months; it feels like many more truly investable opportunities are coming to market with high-conviction managers.
- Investors are settling in on the idea that there will be macro uncertainty for the foreseeable future, so asset quality and previously exhibited resiliency has kept prices higher in the PE vs. public world.
- However, we are seeing a slight uptick in value plays driven more by interesting seller dynamics – seller fatigue from failed processes, tax-driven events, etc., vs. depressed earnings.
- Our equity investment approach in this environment remains consistent:
- Invest in sectors that are resilient, and products and services that are mission critical.
- High earnings and asset quality are paramount.
- Consolidation plays and deals with very apparent bond/call profiles: This is where we have really spent time and made commitments over the past several quarters.
- Alignment in deals alongside GPs who have sector expertise and have invested through cycles.
- Pricing equity returns at levels appropriate for the higher cost of debt and reduced leverage levels, which drives moderating valuations.
- Overall, our view is that it pays to be patient and only deploy into the most compelling risk-adjusted situations.
- Outlook: Things to Watch
- You can’t ignore the macro. Hard or soft landing? Recent discussions of a no-landing scenario could be cause for concern but could also support the view that the right strategy is to buy quality with quality with a view towards medium- to long-term value creation.
- Our strategy is designed to take advantage of any environment, with dry powder (~$2 billion) and pacing to strike a nice balance between patient and opportunistic.
- Fundraising is still difficult, with many groups raising their prior fund size and seeing progress stall out. While investor relations teams are working harder than ever, many are still faced with the decision to extend fundraises or reduce sizing expectations.
- Despite the difficult fundraising environment, HL saw 298 new fund launches in Q1 2023, which is up slightly compared to the 296 seen in Q1 2022. Yet this is down about 10% from 332 launches seen in Q1 2021, which was a record in our dataset.
- Valuation data points for Q4 are still being aggregated given the elongated year-end audit process, but with a meaningful portion of data reported, buyout funds in aggregate are expected to be up about 5% to 6%, which should lead to a slightly positive returns for the strategy in 2022. While Q1 data has yet to be reported, public market data would suggest it will be a strong quarter for private markets as well.
- Debt financing is still more difficult to source and certainly more expensive with basis rates. While a boon to returns for the private credit general partners, buyout sponsors are getting creative to get some deals done. A few themes emerging include:
- Premium for companies with portable debt structures
- Partial sales/non-control deals
- Preferred equity solutions
- Speaking of debt and raising interest rates, this continues to put pressure on interest coverage ratios for levered buyout deals. While distressed debt groups think this will turn into a massive opportunity set for them, many general partners have put hedges in place, had established covenant light structures or are working with credit providers to reduce this risk. Only time will tell who is right, but we don’t expect the massive opportunity that the distressed groups are predicting.
Hamilton Lane deal flow:
Despite a volatile market, 2022 impact-specific deal flow has surpassed the record levels from 2021. Our deal flow sourcing engine is working well; we’re seeing deals from sponsors as well as direct from businesses and advisors.
Impact funds continue to proliferate, with Hamilton Lane seeing more self-identified Impact funds than ever before, and a 12% increase over 2021’s record number.
Market and macro:
Adjacently but important to the overall market, President Biden used the first veto of his presidency to overturn potential legislation that would require retirement funds to disregard any ESG factors while investing.
Financial market participants are watching closely as the industry works to comply with SFDR regulations and the new reporting requirements take effect.
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.
Specifically in the U.S., more than half of new U.S. electric-generating capacity in 2023 will be solar according to IEA (with only ~15% coming from fossil fuels).
We are starting to see an influx of deal flow as groups gear up for the effects of the Inflation Reduction Act of 2022, a piece of regulation to address climate action that includes $370 billion in clean energy and climate investments over the next decade, which will help to accelerate the clean energy transition.
- Despite a more volatile credit environment, banks are still willing to support transactions underpinned by high-quality infrastructure assets, and indicative pricing of SOFR + 300-350 is typical in the bank term loan market.
- We continue to consider middle-market infrastructure funds and direct investments as relatively more attractive, as middle-market deals provide GPs the flexibility to pursue value-add platform growth investments, or to transact with market participants overlooked by larger infrastructure GPs.
- A broader range of clients have expressed interest in energy transition opportunities. Energy transition encompasses a range of opportunities including growth investments in nascent technologies, EV charging stations, offshore wind, transmission development, carbon sequestration, green hydrogen and natural gas. We see significant deal flow across these sub-sectors and are looking to selectively deploy capital in opportunities where risk and reward is fairly balanced.
- From a fundraising perspective, the infrastructure market is expected to be busy in the first six months with ~$50 billion earmarked for closing in H1 2023.
- Several managers (e.g., EQT, Macquarie, Vauban) extended their fundraising timelines later into 2023 to take advantage of fresh investor allocation.
- Last year, capital raising was dominated by large cap strategies, with six funds accounting for 50% of total commitments closed.
- However, the second half of the year was for the mid-market funds, which accounted for every fund closed in H2 2022.
- Secondaries volume slowed in 2022 but remained robust, with ~$8 billion of LP and GP-led transactions completed, the latter declining meaningfully in terms of number and scale.
- Pricing for secondaries has remained strong, particularly for top-quality GPs and funds, par pricing can still be achieved for inflation-protected assets with discounts increasing into mid-single-digits more broadly in the market.
Inflation remains high, spurring the Fed to raise rates by 25 bps in March. Both policy and inflation uncertainties continue to pressure the real estate market.
Given the increase in floating rate costs, even the strongest performing real estate properties such as apartments and industrial are facing cash flow shortfalls due to higher debt service payments.
In February 2023, Brookfield defaulted on loans tied to two office buildings in downtown Los Angeles, and PIMCO’s Columbia Property Trust defaulted on $1.7 billion of office loans. In March 2023, Blackstone defaulted on a €531 million bond backed by a portfolio of offices and stores owned by Finnish company Sponda. These high-profile defaults signal pockets of distress ahead, particularly in the office and retail sectors. We believe the distress may provide a great opportunity for investors.
As $1 trillion of commercial real estate debt becomes due over the next two years, distressed and opportunistic investors are preparing to act as capital solution providers to borrowers that are facing the refinancing of properties that have declined in value.
As a result of the recent banking crisis, the availability of debt financing for commercial real estate, particularly from regional banks, is likely to pull back. This exacerbates an already cyclical lack of financing in the market and creates opportunity for real estate debt funds to step into the financing gap and achieve equity-like returns.
The market is seeing a sharp pullback from core and core plus buyers as open-end funds and private REITS face redemption requests, which have curtailed their buying power.
- Many themes from 2022 have carried into 2023: record-setting deal flow and attractive discounts, but with bid-ask spreads impeding some transactions
- Secondary market volume fell from $132 billion in 2021 to $108 billion in 2022, while Hamilton Lane deal flow grew from $206 billion to $240 billion. This divergence reflects the lower deal closure rate of 2022.
- Deal flow continues to pick up steam in 2023 and is on pace to exceed the 2022 record.
- Average pricing fell from 92% to 81% in 2022. The deals getting done tend to involve high-quality funds, which continue to trade in the 80s – 10+ points lower than a year or two ago.
- More LPs are agreeing to sell at these levels, due to PE overallocation and/or a view that discounts are defensible given the volatile market environment and lack of meaningful write-downs to date.
- LP portfolios both large and small are coming to market. Portfolios are often split across multiple buyers, as buyers run harder at funds they know best in an uncertain environment.
- Other themes have included continued GP interest in continuation funds and more discussion of complex secondaries.
- Supply of GP-led deals has exceeded buyer appetite, leading to discounted pricing or some deals not getting done. Barring material discounts, only the highest-quality GP-led deals with strong alignment will get done in the near term.
- Complex secondaries include structures intended to bridge bid-ask spreads, providing downside protection to buyers and/or upside sharing to sellers.
- Secondary market undercapitalization has enabled buyers to be selective and disciplined.
- Hamilton Lane’s relationships, scale and flexible mandate continue to provide a massive opportunity set. Our proprietary information, micro approach to underwriting, and bias toward quality are as important as ever in the current market environment.
- Themes in HLSF VI’s seed portfolio include (1) LP deals with high-quality GPs and 20%+ closing discounts and (2) structured transactions providing HL a preference on cash flows and/or minimum returns that are well protected.
Venture Capital & Growth
- Venture Capital
- While Hamilton Lane saw marginally fewer new funds come to market in Q1 2023, relative to the same time last year, the messaging from GPs is that funds will take longer to raise, and we have even seen some GPs do what was unthinkable a year ago – cutting down their fund sizes to right-size with a lower valuation environment.
- Over the past few years, late-stage investors have been investing in earlier stages of venture financing where valuations were lower. Now that valuations have come down across stages, the risk/return and attractiveness across stages are beginning to rebalance at varying degrees.
- Growth Equity
- We are still observing a divergence in fundraising results between growth-stage companies that can shift to efficient growth models and those with high cash burn models or still in the process of figuring out their unit economics.
- The combination of record dry powder, companies not wanting to be in the market and investors being extra cautious about deploying capital is creating an interesting dynamic in the growth equity landscape that we continue to watch very closely.
- Other Trends
- Venture secondaries activity is picking up as the IPO window remains closed and pressure on GPs and LPs to find liquidity continues to build; nevertheless, a significant bid-ask spread remains a limiting factor to finalizing deals
- Previous areas of interest, including crypto and fintech, have been supplanted by generative AI and energy transition in 2023. Although these fields remain frequently mentioned as areas of focus, there is still considerable debate over where the most value will be generated in each of these fields.
- While there has been some easing in Europe, growth in the medium-term will remain challenging with anticipated rate hikes by the ECB, a gradual withdrawal of fiscal support, and remaining concerns around consumer confidence and energy supply next winter. This is further compounded by the turbulent financial markets in Q1 2023 following the failure SVB and shortly after, the collapse of Credit Suisse which was bought by UBS.
- The ECB projects annual average GDP growth to slow to 1.0% in 2023 from 3.6% in 2022, and inflation to average 5.3% in 2023.
- Inflation in the Euro area was 8.5% in February 2023 but is expected to fall to 6.9% in March 2023; food price increases continue to drive higher inflation.
- A further 0.5% rate rise by the ECB effective 22 March will see the main rate increase to 3.5% and deposit rate increase to 3.0%; predictions of a further 0.25% rate risk in May 2023 have begun to circulate.
- The UK Chancellor continues efforts to revitalize the UK economy, delivering his Spring Statement in mid-March citing an improved outlook on the UK economy, including optimistic inflation expectations for y/e 2023 which is expected to somewhat normalize to 2.9%. Inflation is expected to remain above 10% for March 2023, despite initial expectations that it would fall below this level at quarter-end.
- The UK base rate continues to rise with another 0.25% increase by the BoE to 4.25% on March 23 and hints of a further 0.25% rise in May 2023.
- Despite best efforts to improve the UK economy, the IMF has taken a more pessimistic stance, recently predicting the UK economy would shrink by 0.3% in 2023, placing it at the bottom for GDP growth across the G7.
- While global PE fundraising activity scaled back in 2022, Europe specifically experienced a 56% YoY decline in funds raised as the region was rocked by the war in Ukraine, and subsequent energy crisis, and political and financial instability.
- China’s implementation of a registration-based mechanism for public listing was well-received by the market as the first batch of shares under the new system surge. The reform is designed to simplify listing requirements and improve vetting procedures, where China Securities Regulatory Commission ("CSRC") will take on a supervisory role for final approval based on the recommendation provided by stock exchanges
- The FIT Asia team was recently on-site in India, conducting comprehensive analyses of the Indian venture capital landscape. We have engaged with 12 venture managers, including top-tier global brands (e.g., Sequoia, Accel) and many other well-established local players.
- We have identified several challenges in the Indian venture market, such as limited wallet share to spend on technology, strong competition from U.S. tech incumbents, consistent currency depreciation, limited institutional funding and a scarcity of exits/IPOs.
- Despite these challenges, the overall outlook for the venture market remains optimistic. The rapidly-expanding middle class is expected to significantly enhance company revenue and profitability over the next decade and offer opportunities for the emergence of more outsized unicorns, along with a diverse range of opportunities in both consumer and enterprise sub-sectors.
- Direct deal flow volume has seen a significant uptick post-Lunar New Year, with the bulk of deal flow coming from non-China and cross-border opportunities.
- Many of our venture sponsors are using HL as a potential source of growth capital for their portfolios’ late-stage fundraising and sizing their total exposure. Opportunities are more bifurcated in quality, either portfolios that continue to raise up-round or flat-to-down rounds (with some secondary) to further institutionalize cap table and diversify investor base. As such, we need to be very cautious on business models that are proven, preferably in high CR5 sectors.
- We have seen equity GPs building out their credit solutions to allow for flexible deployment of capital across the capital structure, ranging from senior secured to venture credit. As credit becomes more prevalent in APAC, we are likely to see increasing direct deal flow, albeit with caution given the new strategy for GPs.
- We have seen growing secondary deal flow since early Feb, as the fundraising market hit a 9-year low in Q4 2022. GPs sought GP-led transactions & LP interests as one of their main routes for fundraising and liquidity. Sellers are showing less appetite for deep discounts and pricing expectations continue to rise along with the picking up of macro and public markets, while they are more open to structuring bids, which helps bridge the gap when a discount is optically high for a cash deal.
- Geographically, secondary deals (by dollar amount) from non-China GPs in our pipeline are on the rise, with Korea & Japan contributing to an increasing portion of our deal activities.
Credit: This strategy focuses on providing debt capital.
Infrastructure: An investment strategy that invests in physical systems involved in the distribution of people, goods, and resources.
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.
Secondary FoF: A fund that purchases existing stakes in private equity funds on the secondary market.
VC/Growth: Includes all funds with a strategy of venture capital or growth equity.