MASTERCLASS: Private Equity

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  • 58 mins 44 secs
Private Equity is relatively new to a lot of financial advisors and individual investors, but institutions have been investing in this asset class for decades and we are seeing a major democratization of the space unfold. This panel explores the push to add PE to Target Date Funds, explains the benefits of evergreen funds, and looks at attractive opportunities in the private markets.
  • Jeremy Held, CFA, Managing Director & Portfolio Manager, Bow River Capital
  • Daniel Wilk, Executive Director, Client Portfolio Manager, FS Investments
  • Bob Long, CEO, StepStone Private Wealth

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Jenna Dagenhart (00:06):

Hello and welcome to this Asset TV Private Equity Masterclass. Private equity is relatively new to lot of financial advisors and individual investors, but institutions have been investing in this asset class for decades. Today we'll cover the democratization of the space, explore the growth of evergreen funds, and look at different opportunities in private equity. Joining us now, it's an honor to introduce our panelists. Jeremy Held, managing director and portfolio manager at Bow River Capital. Bob Long, CEO at StepStone Private Wealth, and Daniel Wilk, executive director, client portfolio manager at FS Investments. Well everyone, thank you so much for joining us and kicking us off here, Jeremy, why has private equity been such an important part of institutional portfolio is for so long?

Jeremy Held (01:01):

Yeah, thanks, Jen. That's a great question. And it's pretty simple when you boil it down. It's really two factors. It's been return and diversification. For many of these institutions that have been investing in private equity for decades, the private equity allocation has been the best performing part of the overall portfolio. And in fact, the differential between private equity and everything else has been so great that there's actually a push from a legislative standpoint to make sure that defined contribution and 401K plans actually has access to the same investments that define benefit plans and institutions have used for years in their portfolios. And when you think about the benefits to institutions of using private equity, whether it's performance or it's diversification, the factors that existed 20, 30 years years ago are even more relevant today.


I think it's been pretty well-documented that there's fewer public companies that exist today than ever before, and the public... and the private markets rather are just growing that much faster. And I think an argument can be made, and some have made this, that the private markets are really the source of growth and innovation in the country going forward. If you think about 85% of all companies with 500 employees in this country are private. And so to have access to that level of growth and innovation in the country is really important and that's why these institutions have been investing there for decades.

Jenna Dagenhart (02:29):

And I'm sure we'll talk a lot about evergreen funds today. So I want to start by defining them. Bob, what are evergreen funds?

Bob Long (02:37):

Sure. So to tie back to what Jeremy said, the return benefits and diversification benefits of private equity are fairly well-known and documented and virtually all large sophisticated institutions and the highest net worth individuals have long allocated very large portions of their portfolio to the private markets and private equity specifically. But the barriers for individual investors to investing in private equity have been enormous. And the evergreen funds that we all work on with our firms are designed to overcome those barriers. So the typical private equity fund has unpredictable capital calls and distributions. And in fact, when you commit to a new fund, you're committed, you're not even fully invested. It's not at all like investing in a stock or mutual fund.


So you make a capital commitment, it's drawn over time, the capital comes back to you unpredictably. Really hard to have a disciplined asset allocation. On top of that, the minimums, even if you go through a sophisticated private bank or at least 250,000 and often much larger to get access to a quality manager.


Finally, if you get through all of that, you're able to diligence and select a private equity fund, meet the minimum, achieve a diversified portfolio because you're large enough to commit multiple $250,000 or larger checks to create a diversified portfolio. After all of that, you find yourself with very complex tax reporting in the form of a Schedule K1 that comes in October when you wanted to file your taxes in April. So the evergreen fund solved this. They're permanent capital vehicles like a mutual fund. Your money is immediately invested and we manage the cash, we get it invested in private investments for you. You're immediately invested. The minimums are typically quite modest. 25 to $50,000. And then we provide regular transparent valuation. In our case, in one of our funds, we do daily, the other's monthly, and then we provide a 1099 in tax reporting, which you get in January. So the evergreen funds are a much better solution for the typical high net worth individual, or even small institution who wants to access the benefits Jeremy described in a more user-friendly package.

Jeremy Held (04:58):

And I would just add to that, I mean I think from Bob's comments, immediately invested and diversified are huge benefits to investors. But one of the things that we've seen with our portfolio and I'm sure is the same with Dan and with Bob, is just the flexibility because these are not vehicles you commit to over one time and then the next vintage fund doesn't come up for three or four or five years. The flexibility from an asset allocation standpoint, each of these funds you can add to on a monthly basis. There's a limited liquidity option on a quarterly basis. And of course, the lower minimums and the more simplified tax reporting makes these very popular with high net worth individuals.


But we've seen a lot of interest from the small institution and even larger family offices side. I think two of our largest investors are billionaire single family offices, and they love the fact that they can use evergreen funds as a tool that compliments their traditional private equity portfolio. So I think the use cases are broad and I think that this is a structure that you're going to see really grow. I think evergreen funds are one or 2% of the private capital markets today, and that number is clearly going to five 10% and beyond because there's so much applicability not just for small investors but medium and large investors as well.

Daniel Wilk (06:14):

And to build off that, I mean the points all resonate across all of our platforms. The ability to immediately allocate capital, have no capital calls, simplify tax reporting. But even on the other end, these typical limited partnerships come with a 10-year lockup. But it's the best told white lie on the private equity sphere because the typical vintage post GFC is 13 and a half years. So with respect to just portfolio construction, if we think about the advisor community, it's very difficult to achieve a tactical weighting to private equity because an investor's percentage allocation in a portfolio depends on a couple things. The overall capital committed, the speed at which that capital is drawn down and invested, and then the advisor's ability to redeploy distributions on the backend in order to maintain that exposure. Evergreens offer a really unique way to get institutional grade private equity exposure in a more operationally friendly vehicle.


And there's the old adage, in order to achieve the benefit you need to be invested. And an advisor's ability to immediately compound those returns, it's just basic math. You'll actually get to your multiple faster in an evergreen vehicle than you will in a limited partnership just because they have to work through with the investment and drawdown period. Now to the other point about larger institutional capital at the larger end of the market, we're seeing applications within the multifamily office, ultra-high net worth and pension space as portfolio managers are now realizing that they can use a more tactical core satellite approach with respect to their PE exposure. Within that typical allocation mandate, your core is going to have much more passive exposure and that really doesn't exist in private equity.


Private equity by nature is active, but with evergreen funds you can now have passive operational exposure to stay invested and it's allowing portfolio managers to then satellite around opportunities for attractive alpha. So whether that be a growth equity portfolio or some AI venture book, the ability to have your core and satellite around it has resonated both individual clients and even the high end CIOs.

Bob Long (08:21):

I totally agree with that and I suspect my colleagues, panelists here will agree. When I'm asked what we do at StepStone Private Wealth, I often describe it as because we're part of a much larger organization, $600 billion, we believe we're the largest allocator to the private markets globally on an annual basis. What we do is focus on compounding your capital. We are less IRR-focused, we're for investors who want to compound their gains, as Dan described.

Jenna Dagenhart (08:48):

And Jeremy, I saw you nodding your head as well. Anything you would add there?

Jeremy Held (08:52):

No, I mean the only other thing I would say, and it really piggybacks on Dan's point about a core satellite approach, is that all of the obstacles in a traditional private equity fund that exist are compounded in the financial advisor role, because it's very hard to maintain consistency across clients. You may have some clients that are in one drawdown fund, other clients that didn't make the window. And so having a core portfolio that can be consistently applied from a model perspective in the private markets pretty much did not exist prior to evergreen funds. And so just the applicability of making sure that your clients have a similar portfolio with similar risk profiles was very hard to do given the heterogeneous nature of a traditional private equity fund. There's a lot of benefit to having a core solution that every client will have the same exposure.

Bob Long (09:45):

Before we move on from this topic, I feel like we haven't fully addressed the liquidity piece. Maybe I'll comment on that. So these funds typically have monthly entry. We've just made our core fund a daily entry fund. So you have regular entry and then you have quarterly liquidity. And in general, the funds offer liquidity for 5% of the fund. Not of your investment, but of the fund at 100% of net asset value. So the idea is most investors can exit their investment most of the time, not in every single worst stress case scenario, but most of the time at 100% of net asset value at 30 to 60 days notice depending on the fund. So back to the comments made by the other panelists, this is a portfolio tool that just wasn't available before.


But liquidity piece is important. I think of it as a hybrid. It sits between your daily traded exposure, which might include BDCs and REITs and other things that have some diversification benefits, and your 13-year drawdown funds as Dan described, because that's really what they are. 13 to 15 years. This sits in between... It's not perfect. It has some disadvantages in comparison to both, but you can't sell it every day. But when you do sell it quarterly, you'll like the price because you'll get 100% of N. So that's how it fits from our perspective.

Jeremy Held (11:13):

Yeah, I think Bob, the question that our advisors ask their clients on a very frequent basis is they ask their clients, do you need to have 100% of your assets, 100% liquid, 100% of the time? And if the answer to any of those questions is no, the opportunity set that you can open your clients up to by investing in the private markets is immense. And I think the answer in almost every case for clients, they're hiring a financial advisor to build a 10, a 20, in some cases, a 30, or a 50-year plan. They typically don't need to have all those assets liquid every day all the time. And just opening up that opportunity set is really important for ad advisors and clients to build better portfolios.

Jenna Dagenhart (11:59):

Yeah, that's a really great point, Jeremy. I mean, rarely is the answer yes to all those questions. Anything you would add on liquidity, Dan, before we move on?

Daniel Wilk (12:10):

Yeah, I think at the end of the day, instead of sponsor-mandated or GP-mandated liquidity, you're now putting more investor controls. And when it comes to portfolio construction, that's all that matters. The individual client and giving them discretion to control their timeframe to an extent.

Jenna Dagenhart (12:26):

And now Bob, StepStone Private Wealth has seen significant growth over the past three years, launching new funds and crossing a billion dollars in assets under management. How have you achieved this growth and why have your funds resonated with investors?

Bob Long (12:41):

Well, I have a great sense of timing. We brilliantly launched our fund in April of 2020, because COVID was going to be no big deal. I also had an appendix out on my honeymoon. I have a long history of counter-timing. We could talk about that. Look, we've been extremely fortunate. We did launch at a difficult time, and our first close, a total of $35 million was 25 million from friends and family. So my wife was looking at the weather in Canada every day, because that's how far we were going to have to move if it didn't get off the ground. But we launched in on October 1st, 2020, bought a lot of secondaries, had really good performance. Of course past is not prologue. We've been thrilled with the performance we've had, and that allowed us to grow in the core fund. Then we launched a venture fund where I believe our timing is particularly good.


We launched it in the fourth quarter of last year in a world where we believe venture assets and growth assets have been repriced attractively. So those themes have resonated. But I think the other panelists, the key is to create investor centric products. And what you have here, three of what I believe are the higher quality providers in this market, you can't succeed unless you make life easier for the financial advisor for their client. And we like to define that is focusing on efficient, which is a nice word for inexpensive, transparent, which is no surprises, and then convenient, easy to do business. And we could address this. I think all of us would agree, the first two pieces are actually the easiest. The convenient piece, making this convenient for investors is the hardest piece. But focusing on those is what's allowed us to grow to about a billion eight as of today. And we're launching a third fund soon in the infrastructure space, which we believe will drive further growth.

Jenna Dagenhart (14:30):

And Dan, would you be able to give our viewers an overview of the US middle market and explain what's driven some of the historical outperformance there?

Daniel Wilk (14:39):

Yeah, absolutely. So the question we appreciate because we recently formed a joint partnership with Portfolio Advisors. They've been around for 30 years, founded their business in '94. They invest across every transaction type within this US mid-market. And then the mid-market... everyone says there's an access issue, but in the mid-market, there truly is. Managers are naturally capacity-constrained based off the amount of capital they can raise, the type of companies that they can own, and then if they're anything worth their weight for performance, they're going to be oversubscribed. So institutional capital has been really gravitating towards this mid-market space. And we would define it on the lower end. There are a couple different metrics you can look at. We look at total enterprise value between 25 million and 500 million. And this is really where the action is, particularly on the buyout space. About 90% of all deal count volume occurs within this segment.


And then by sheer size, there are a lot of companies that you can focus on. There's over 100,000 different private companies within this market. Compare that to publicly traded equities, a little north of 4,000. But what's different here is that 80% of mid-market buyouts are actually purchased from a strategic seller, meaning someone like a family owner, operator, a founder, or even a parent company. And that differs from the large cap portfolios where the vast majority of those buyouts are actually done through other financial sponsors or through buyouts of public companies. So why we like that is because the mid-market has different characteristics for these companies. The transactions require less leverage, there's lower purchase multiples, there's a much easier path to liquidity. But said more simply, it is a space where managers can best execute in information edge and value creation levers.


So whether it's value creation through a strategic acquisition, operational improvements, expanding the business into a new segment, there's really more flexibility within this mid-market or this lower end of the mid-market. And it's led to sponsors outperforming. So mid-market buyout sponsors outperform their large mega cap peers at both the median and then sizeably in the upper quartile to the tune of 500 basis points. So for us being able to form a joint partnership with portfolio advisors as our institutional private equity arm operate in evergreen fund and leverage their relationships of GPs and sponsors within this segment we're excited about because again, it's everything my other panelists are saying. This diversified growth component and introducing that to client portfolios.

Jenna Dagenhart (17:11):

Jeremy, what are some of the major strategies within private equity and how are they different? Could you give our viewers an overview of that?

Jeremy Held (17:20):

Yeah, and I just want to piggyback and agree emphatically with what Dan said. I mean, Bow River, we've been a lower middle market private equity firms since the early 2000s. And I think that that is in our view clearly the best risk adjusted returns in the private markets. But it brings up another point. I think one of the most important things people should think about when they look at private markets is just how different the components of private market strategies are. I think that in the traditional asset class world, we've become now ingrained in style boxes. And I think that people understand the differences between large and small stocks and growth and value in domestic international. But I think you could argue that the differences among private market investments are far greater than they are among different stratifications of public companies.


I think this year is notable because you're actually seeing a difference between say, large growth and small value. Well, the reason why it's notable is because for years, the correlations between different asset classes within public equities have approached 90 or 100%. You contrast that with private equity, which a lot of people think of as this homogenous pool. There's massive differences between venture capital, which is early stage companies in many cases, pre-revenue companies. Growth equity, which are fast-growing companies, but typically not profitable because they're reinvesting all that cashflow into sales and marketing. You then get into the buyout space, which Dan articulated very well. There's massive differences between a small company buyout that has $30 million in profit, has multiple levers both organically and inorganically to grow then say a 10 or a $15 billion take private large cap transactions.


So what I think you'll see in the future, and maybe it doesn't mimic exactly the style boxes, but as private markets go from being 5%, 10% upwards of 20, 30% of a client's portfolio, you will see distinctions. It's very common for us, and Bob and I talk about it all the time, we're often paired as a mid-market co-investment fund with a secondaries fund. I think it's very common to see a large cap co-investment fund paired with a multi-cap fund. And I think you'll see, and Bob talked about it from a product development standpoint, they've got an earlier stage growth equity and venture capital fund. There's infrastructure on the horizon. So I think because this asset class is new to a lot of advisors, they think about it as just, oh, I own my stocks and my bonds, my mutual funds, my ETFs, and then I've got this private market allocation. But there will be stratifications. And I think those distinctions are perhaps even more important because the differences are greater. And you'll see groups having two, three, four, in some cases, six or eight private market solutions potentially just in the private equity asset class.

Bob Long (20:11):

And if I could build on that, combine that with what Dan said earlier. So let's say you're an advisor and I'll speak blatantly about something we're excited about now. Infrastructure. You've read the headlines, you and your client think you want to get money invested in infrastructure. Well, if you found infrastructure funds to commit to and started committing to them today, you might get to that target allocation in, I don't know Dan, what would you say, five years maybe?

Daniel Wilk (20:37):


Bob Long (20:38):

If you believe as we do, that... and for us, pretty interesting right now, really the only way to get in invested, not just committed but invested, is through an evergreen fund solution. And the same would apply to all the products discussed here today. You just can't get there in any reasonable timeframe without using an evergreen fund.

Jeremy Held (21:03):

Bob, it's funny you mentioned that. I sit on a charitable board, it's one of the oldest foundations in Colorado, and it's about $100 million corpus to the foundation. And we've got an advisor on it, a consultant, and we're about 4% in private markets. And their goal is to get us to 20% and they have us on an eight-year glide path, which to me just seems not-

Bob Long (21:27):

Jeremy, you're not doing your job.

Jeremy Held (21:28):

So we're working on it. And the reality is that is the old way of investing in private markets. And five years ago, 10 years ago, nobody would've thought twice about that. That's just what happens. That's how long it takes to get invested. Now that there are ways to get money in the ground compounding a return, as Dan Dan mentioned, it's a faster way to get to multiple. And you look at every institutional investor over the past 30 years and you rank them top to bottom. Yes, you have to be right more than you're wrong on the investment side. But what separates the very successful investors from those that aren't is they hit their target allocation early and they kept it. And evergreen funds are a great way to do that.

Bob Long (22:07):

And just to say a word here, the reason you can create evergreen funds today is because you've got valuation. The advancements that have been made in accurate valuation to allow ins and outs at fair values have turbocharged the ability to create evergreen funds. So that's a whole separate conversation. But I'm sure my panelists would agree, valuations today with the technology we have, the back testing we had, are something we as fund sponsors and our investors can have confidence in, which is what allows you to have regular entry and regular exit at fair value. It's just been a critical development really, I would say since the financial crisis.

Jeremy Held (22:53):


Jenna Dagenhart (22:53):

And I want to talk a little bit about the denominator effect. Dan, could you explain the denominator effect happening within the institutional community that's resulting in attractive LP-led secondary pricing?

Daniel Wilk (23:08):

Yeah, yeah, absolutely. It's a good question. It relates to market commentary right now, and I'm not sure which panelists mentioned how well private markets have performed relative to public over time. But if you think any institutional investor, whether it be pension endowment, sovereign wealth fund and so forth, they've all made sizeable allocations to private equity. This denominator dynamic is simply private markets consistently outperforming, which is skewing their weighting in portfolios and it's now getting outside of their mandate. So with somewhat of a reset valuations and a large number of PE sponsors going out looking to raise capital, in order to maintain these high quality GP relationships, investors are having to re-underwrite their PE exposures in their current book. And what they're doing is they're selling off some of their non-core assets or they're consolidating managers and they're freeing up room in the portfolio in an effort to continue to allocate to the space.


Because of this, you've seen secondary volume north of 100 billion for two consecutive years, but over the last 12 months it's really shifted to what I think we would all agree, a buyer's market. What I mean by that is, within the LP-led secondary space, if you're acquiring a fund interest from a selling LP, you can do so today, 80% of fair value in the buyout side, 60% of fair value on the venture side. So what that means for our listeners, it's really you're acquiring a portfolio at a discount and you're provided with an immediate baked in unrealized gain equal to the spread of the discounted price and the fair value of the portfolio. What that does is it serves as downside protection for a cushion for any valuation adjustments that occur. And then your performance going forward is really just the performance of the secondary that you ultimately acquired.


We think that that's a really important dynamic for the allocating community to understand pricing today. But pricing isn't the only end all be all dynamic. I think that's just as equally as important. I was sitting down with the portfolio managers, with portfolio advisors, and we basically were walking through the secondary market. We were looking at pricing and their philosophy is just focus on higher quality sponsors. We're able to source through primary relationships. This allows us to basically focus on acquiring fund interests based off of access and not simply based off price or owning things at discounts. The team really prefers to execute carve out transactions where we're actually bidding on a specific set of assets in order to be price makers, not necessarily price takers. And the reason we want to do that is because if you can own really high quality assets that are going to compound and grow over the long term for an institutional grade evergreen portfolio and do it at a discount, that's certainly gravy. So for the next 12 to 18 months, it's a compelling segment on the LP-led side.

Jenna Dagenhart (25:55):

And Bob, you mentioned infrastructure. Any sectors, asset classes you see opportunity in over the next one to five years? It sounds like the answer is yes, but would you say that now is an opportune time to invest in the private markets?

Bob Long (26:09):

Well, let's step back a little bit though. Private markets, as Jeremy has described, have outperformed now for decades in a meaningful way. That's not news. But private markets have particularly outperformed during periods of dislocation and uncertainty. And my opinion about whether recession is coming or not is no more valid than anyone else's. But if you believe one is coming, then this is a particularly good time to invest in the private equity market. Now, stepping back from that, being a little more tactical, we believe that the dislocation in the venture capital market is particularly acute. There were numerous tourists in that market. A tourist investor is someone who comes in when a market is hot and leaves the minute that it's not. And that inflated valuations and volumes and you can see the graphs, we can put them up, you can see them on our website.


That market was inflated. It was a bubble. Now it has come down dramatically and pricing has adjusted dramatically. And back to my valuation point, those valuation marks have been taken by the top quality venture managers. So what you're seeing today is a realistic view here at June 30th, 2023, or the June quarter of 2023, a realistic valuation. So we believe that accessing secondaries for venture, and as Dan described, if you think about middle market private equity as being access constrained, venture is even more access constrained. There are even fewer good managers and relationships are even more important. And we are the largest allocator to that market in the world by a wide margin.


So we think venture secondaries are particularly attractive at this point in time, and it does give you the ability to access the innovation economy and the growth sectors at a discount with the margin of error as Dan described.

Jenna Dagenhart (28:10):

And Jeremy, what about you? What do you see as the most attractive areas in the private equity market?

Jeremy Held (28:15):

Yeah, I mean, I'd really agree with both Dan and Bob. I mean, I think our core focus is mid-market private equity, and I think for all the reasons that Dan articulated before, more leverage for growth, lower leverage, better inorganic growth, way more exit options. One of the things that we didn't even talk about is just the IPO market is closed and it will open again at some point. But I think one of the things that that's interesting is that people think about the only private equity investments are those that are going to go public, and there's so many more exit options. And so what we always want to look at when we're underwriting an investment is, okay, is the value creation plan credible? And then what are the exit options? And to have that many more options from both strategic sponsors, financial sponsors, private equity firms, we don't have a single asset in our portfolio today that it's exit plan is to go public.


And so the IPO window will open again and that's going to be great for all capital markets. But we love the middle market private equity. But to piggyback again on what Dan mentioned and Bob, the secondary market can be very interesting. It can be very episodically attractive. We talk about secondary offering the three Ds for investors. It's discounts, it's diversification and it's distributions. And that can be very additive inside of a portfolio. And I think what each of the portfolios from the panelists that are on this call today, offer investors is two very important things that will allow you to achieve your returns, which is dry powder and a flexible mandate. So because these funds take in capital on a monthly basis, we're continually utilizing that dry powder to invest in new opportunities. And because we have a flexible mandate, we can move from mid-market private equity if that's attractive into the secondary market, when that becomes attractive into growth and venture, when that becomes attractive.


And what's hard with traditional private equity is oftentimes you're pigeonholed into just one or two vintages in one or two sectors. So the ability to have dry powder that can pivot and a flexible mandate is really attractive. We love the mid-market, we like secondaries, those valuations could change and you want to have the ability to pivot as that occurs.

Bob Long (30:31):

So you're basically saying that the evergreen fund gives you the opportunity to dollar cost average into good markets and bad, which has not historically existed for the regular way drawdown private market funds.

Jeremy Held (30:45):

100%. And just making sure, it's hard to time vintages. We all know would've been much better if we could put all of our capital into a 2010 vintage instead of a 2005 or 2006 or 2003, instead of 1999. We don't know how those markets are going to play out. And again, back to my point earlier, the most successful investors are disciplined investors that access every vintage year maintain their allocation and around the edges, you're going to hopefully invest more in the better vintages and less in the worse, but you need to have a disciplined portfolio construction approach. What we're offering in each of these three evergreen funds is something that institutions have been doing for years. It was just never available at this level before.

Jenna Dagenhart (31:27):

And Bob, secondaries make up a significant portion of S Prime and Springs Holdings. Taking a step back here, what are secondaries and why do your funds hold them?

Bob Long (31:39):

So a secondary purchase of a fund interest, we'll focus on that, is simply buying an existing limited partnership interest from another investor. And you step into their shoes, you plug into their position in the limited partnership where you own the assets that they owned, or you own the router portion that they own of the same assets, same general partner, same expense load, all of that. And as Dan described, typically you're able to buy those at a 20% or higher discount to current net asset value. And it allows you to, to what Jeremy said, shorten your duration, achieve distributions earlier and immediately achieve diversification.


So when you're designing an evergreen fund, the goal is to start and stay on the upswing of the J curve to avoid the downdraft that the typical private markets fund experiences in the early days of cash flows and costs. And to do that, you need to achieve a mature portfolio. And really the only way to do that is to buy a group of secondaries. So assets that are in the ground and are closer to their realization date, creating distributions and also gains for the portfolio.

Daniel Wilk (32:50):

Just piggyback off that, Bob, I mean I think secondaries also offer this ability to reduce or significantly almost eliminate blind pool risk that's associated with primary investing. When you're committing to a primary round, so you're a main investor, a first investor in a new limited partnership, you're basically trusting on the track record and expertise of the GP that you're working with. And primary funds have obviously done well, but there is a very wide dispersion of returns between top and bottom quartile managers. Because you're purchasing secondaries at a later stage in their life cycle, to Bob's point, you're able to effectively underwrite the portfolio of assets, figure out what fair values are, and during this auction process bid on what you feel that fair value's worth.


So when you think about loss ratios on the primary side, typically about 20%. So 20% of the time a fund will return less than 1%. On the secondary side, the industry average is 1%. So 1% of the time a secondary transaction will result in a performance under 1%. So the ability to have substantial downside protection, underrated a high quality portfolio acquire at a discount is certainly compelling. But think about all of our main points around accessing this diversified growth component. Doing it from a lens of direct equity co-investments and secondaries with downside protection, I mean, there's a really good school of thought for these evergreen vehicles to be core holdings within portfolios.

Bob Long (34:16):

And if you think about it, you could commit to a secondary fund and those exist and we operate those at StepStone. But then your money's coming back to you and you have the reinvestment risk. So the evergreen fund is a constant secondary machine to stay invested and maximize your multiple of invested capital. That's the goal when they work well.

Daniel Wilk (34:36):

Yeah, it's a perfect segue the way we think about managing the liquidity within these evergreen structures. We use the analogy of looking at a bond ladder and that you're constantly tearing out maturities. Within the secondary space, you're doing the same thing. You're focusing on vintage diversification to spread out the risk that comes with investing in any given single year. And then you're constantly having that segment of portfolio turnover, generating liquidity that you need and you can consistently redeploy to Bob's point.

Bob Long (35:04):

So let me jump in there. So there are a number of funds that compete with S Prime, our core fund. We certainly take the philosophy Dan described, but we've chosen, and I think this distinguishes us from many of our peers to have about 25% of our portfolio in the core fund, S prime. In naturally yielding assets. So we have about 25% in real assets, which is infrastructure, real estate and private debt. So in addition to the secondaries, we've got an organic yield to our portfolio coming from that 25% that allows us to support the regular 5% redemption opportunities and also reinvest. So just same theme, but a little different take for our fund. 25% yielding assets along with the core private equity middle market assets.

Daniel Wilk (35:53):

Yeah, it's good to point out, and I think our portfolios do have a yield component as well. But to your point about viewing how you're distinguishing that liquidity into what thresholds is going to vary for all of these evergreen funds, just like fee structures and just like allocation across transaction types.

Jenna Dagenhart (36:09):

And sticking with you here, Dan, we've seen a lot of transformation and growth in the GP-led secondary market. What's been driving this?

Daniel Wilk (36:18):

Yeah, there's a lot of education that's needed here. Candidly, I'm surprised at the level of interest we're getting across the board within all evergreen funds, but on the GP-led side, so there's been a huge transformation following COVID-19 where we saw markets freeze up a little bit, or deal counts slowed. But sponsors began to re-underwrite their operational processes with respect to the path to liquidity for different portfolio companies. So previously the main path for the middle market specifically was to sponsor sales of portfolio companies. You're nearing the end of your fund's lifecycle, you need to return capital to investors as well as realize economics. This timeline constraint of a fund winding down was actually turning out to be a slight drag on investment returns in certain unique situations.


So prior to 2020, continuation vehicles were a way for GP-led secondaries for teams to basically take either troubled situations, troubled assets, or maybe a pool of a few different assets, move them into a different vehicle, provide liquidity for existing investors, but then access a new pool of capital at the secondary market. Post-2020 into present day, GPs have actually re-architected the way they approach this space, and they're actually using this as their top performing or this trophy asset segment. So by raising capital and extending the life for a GP's trophy asset or some of their best performers that they don't want to simply sell to another sponsor, they're actually pulling volume from that sponsor to sponsor sale market over to the GP-led secondary side.


Roughly half of all continuation vehicles that are being transacted on the secondary market are all single asset trophy type deals in some sense, where the GP wants to hold onto the asset longer. But the secondary market overall to speak to that transformation, it's now split 50/50 between LP-led and GP-led. That dynamic did not exist prior to COVID. So there's a school of thought allocating across the secondary landscape both to the LP-led side, for the great comments that both Bob and Jeremy made, and then the GP-led side for more direct exposure or this doubling down with a shorter timeframe with an economic alignment alongside GPs is certainly there.

Bob Long (38:36):

So the way I think about it, all the challenges we've talked about in the drawdown funds, one of them was a GP owns a great asset, but they get to the end of their life and the LPs want their money back. And so they had to sell. And if you're a large sophisticated investor, you might be invested in fund A that's selling the company that you love and has done so well to fund B. And who makes money there? The bankers and the lawyers. So GPs are smart, and they figured out that private equity is an industry 50 years young. I mean the things that a public market investor would take for granted, the way to slice and dice risk to be more efficient, we just didn't have those things. But GP-led secondaries, evergreen funds are critical advancements in making this market more efficient and frankly more investor-friendly.

Jeremy Held (39:26):

Yeah, Bob, I couldn't agree more. And it's one of those things where the whole reason why we're having this call in the first place is that private markets are becoming more accessible. And there's a melding of some of the elements that have existed in public markets forever that didn't really exist in private markets. And really that's flexibility. I agree with you Bob, 100%. The things that a public market investor takes for granted in terms of being able to have precision, not being constrained from a time period perspective, the private market industry has operated in a one size fits all mentality for years. And now this notion that we can go buy a company, we can improve it, and we don't have to sell it if our fund has a 10-year life. We can put it in a continuation vehicle.


The fact that people can now use evergreen funds to compliment their private equity portfolios is so important. And one of the things that we really like about GP continuation vehicles to add on what Dan talked about earlier is it's this best of both worlds combination. If done right with the right alignment and the right asset and the right sponsor and the right fee structure, you don't have the blind pool risk of a new co-investment. This is an asset that maybe a sponsor is owned for three years or five years or seven years. In many cases, it may be their best performing asset. And you don't have that blind pool risk, but then you can also have some of that upside that you get with co-investments. We think direct equity co-investments provide the best long-term total return, but they also have the most risk and the most concentration, the least amount of liquidity.


And you can compliment those with secondaries. GP-led secondaries are a great compliment in that toolkit and we're really glad to see that market proliferate. And they're getting better. I think in 2020 and 2021, a lot of the GP-led deals that came out didn't have the best alignment, didn't have the best fees, to Dan's point, weren't necessarily the best assets. And now you're seeing that this really is a changed market and we think it's a great tool inside the portfolio.

Bob Long (41:29):

I feel like we might have skipped a step, I'm not sure we were really clear for our audience, a GP-led would look like this. It would look like fund A owns 10 companies, sold some of them, two of them are great, they've done well near the end of the fund life. And so they go to their investors and say, "Look, if you'd like to keep owning these companies, you're welcome to. But we have secondary buyers like the firms represented here who would also like to own it. And so if you'd like to sell or like to sell part, you're welcome to." So this is the GP getting options to the LP. You also avoid the frictional cost, which in the lower middle market could be as much as 5% to sell a company. So you avoid that. But again, it's an option for the limited partners, not something forced on them in the continuation fund. Now there are other themes of GP-led secondaries where there's less choice, but that's probably a longer conversation.

Daniel Wilk (42:27):

Yeah, and I think to your point, it's an opt-in or opt-out conversation. LPs have yet to really embrace this for the existing side, 90% of them are actually opting for liquidity. But the performance of the GP-led side has been very strong and there's research coming out showing that more folks, if they do not need the liquidity, should participate in these continuation vehicles. And to quantify some of the economic alignment, about 46% of these continuation vehicles are starting with the GP realizing 100% of their economics being rolled into this new fund and an additional commitment. So when we speak to it's a trophy asset, they're effectively doubling down to some sense, that's really what we mean. They're aligning their economic interests with the new investor pool that's coming in to access this portfolio company or companies.

Jeremy Held (43:17):

[inaudible 00:43:19].

Bob Long (43:19):

And third party capital, so say one of our firms is pricing it. The GP puts a value on it. It doesn't attract investors, it doesn't sell, but the third party capital is providing a discipline for the benefit of those selling and those staying that the price made sense. So it's a really nice tool and it should grow as described.

Jenna Dagenhart (43:40):

And looking at the current environment, Dan, how are higher borrowing costs impacting co-investment activity?

Daniel Wilk (43:49):

Yeah, it's a good question and it transitions to a lot of what Jeremy is saying on the co-investment side right now. I think higher rates certainly make it more expensive for businesses to take on additional debt, which can ultimately stifle growth and then also reduce private equity returns going forward. But when you look at it overall, private equity returns on a historical basis. Are still going to produce anywhere from three to 500 basis points above where your expectations are for publicly traded equities. So regardless of this higher borrowing cost segment, you want to focus on that active management component and effectively GPs coming in, buying to sell. They're buying to sell and that they're coming into the market identifying a certain company with unique characteristics where they can execute a strategic value creation initiative and then they are economically incentivized to maximize that value, maximize that alpha.


On the sourcing side, I think it is fairly unique and probably lesser talked about in the marketplace, with higher borrowing costs, coupled with the denominator conversation we were talking about in the beginning. You're having less primary capital get committed on the LP and the institutional side. So with less primary capital and higher borrowing costs for individual deals, you need a bigger equity check upfront so you're not saddling companies with too much debt. Less primary capital, bigger equity checks. Well, if sponsors want to stay active and they want to allocate dry powder right now, they're going to their favorite LPs and they're sharing a lot of co-investment activity.


Anecdotally, we've seen a 30% uptick in volume shared with us. We only close on about one to 2% of those deals. We really want to make sure we're focusing on the right areas. But from a volume perspective, co-investment activity have certainly picked up on the sourcing side. And we'll now wait to see if you know more and more deals will close as we get into the end of the year and into next year.

Bob Long (45:38):

The way I think about it is the factors Dan described are driving out the marginal deals. The deals getting done today are better deals on average.

Jeremy Held (45:47):

100%. And we had the fortune, Bob and I have shared horror stories over this. We launched our fund in May of 2020. You guys were April of 2020. It was an interesting time to be launching. But I agree, and you brought this up too, Bob, with the tourist comment around venture capital and growth equity. And what you had was artificially low rates really created a lot of dislocation that brought marginal sponsors into the world. Marginal companies. There are plenty of groups that had great returns over that time period. But to Dan's point, all you have to do is zoom out from three years to five years to 10 years to 30 years, and go back and look at the academic data around how private equity performed in an 8% fed fund environment, let alone three or four or 5%.


And it's very consistent over different interest rate regimes. And we actually think that this market that drives out the marginal players puts a little bit of a lid on the excess from evaluation perspective, has created... in our three-year plus life of the fund, we have the highest number of top-of-funnel opportunities that are meeting our underwriting standards. So it's a very exciting time to put capital to work. Again, piggybacks on the point that Bob made earlier about when markets have dislocation, or even if it's not dislocation, but lack of certainty around pricing outcome, that's a great opportunity for private market investors.

Jenna Dagenhart (47:13):

Yeah, and I want to talk a little bit more about valuations. Jeremy, private markets and private equities specifically were very resilient in 2022 when stocks and bonds suffered significant losses. How is private equity valued and can investors trust the valuations?

Jeremy Held (47:31):

Yeah, great point. And I'm sure that there's going to be some other comments from Bob and Dan around valuations. And the advancements in valuations to Bob's point earlier, are what makes all of this possible. 20 years ago when Bow River started, there were two valuations that mattered. What do we buy the company for and what do we sell it for? And it was not that uncommon to see groups hold investments at cost for 12 months, 18 months, 36 months in advance. And really post-GFC, there's been a lot more scrutiny with accounting rules around how are you valuing these assets? And are you valuing based on a multiple of revenue or a multiple of EBITDA? What is your valuation methodology? Has it changed?


If it's changed, why? And it's not uncommon now to see now these are never going to mimic what you're seeing in the daily stock market fluctuations, but it's not uncommon to see a sponsor that owns an asset, and if it values it at 10 times EBITDA, and in the most recent quarter, the EBITDA was up 10%, the valuation goes up 10% and it's 1.1.


And so I think what you find is that the stock market is a voting mechanism in the short term and a weighing mechanism in the long term. And private markets are just a weighing mechanism. And they have a very strict methodology and the companies don't rise up as much in euphoric public market bubbles, and they don't fall as much in market downturns. Everyone asked us, well, what happened in 2022? And we said, "Well, why don't you rewind three years and look at what happened in public markets in 2020 and 2021?" The spread in valuation between public markets and private markets was at an all-time high in November of 2021. Most of what happened in 2022 was a reversion to the mean, and we would argue, even though it's mostly driven by 10 stocks, we're not quite at November 20, 21 levels, but the relative valuation between public and privates is now starting to gap out quite a bit. And that the question should be, why did public markets run up so much and then fall so much the weighing mechanisms in private markets, which are just steady along the way?

Jenna Dagenhart (49:44):

Yeah. Bob, I see you nodding your head, and I want to get your take as well. Could you speak to the importance of convenience, efficiency, and transparency? And then what about the role of data and technology and investment decisions?

Bob Long (50:00):

So convenience, transparency, efficiency are really what make the evergreen funds work for individual investors. I think we've addressed those things and all of us seek to do that. While this is still a relationship business and not 30 or so years of doing it, data and analytics have become more important. You're looking at a broader set of opportunities. You're having to make decisions more quickly. And at StepStone, one of the things we pride ourselves on is the investment we've made in building a very robust set of proprietary tools driven by a team of over 40 data scientists in engineering on our payroll, and a system that we call the Bloomberg for the private markets known as Spy StepStone Private Intelligence, that allows us to quickly access the data we need to make the underwriting decisions that have been described here.


What public markets might not appreciate is all this information we've talked about, it is not required to be posted anywhere. It is not even required to be made equally available. So as Dan talked about being a preferred primary committer, we commit about $70 billion a year to the primary markets. And if you're committing capital to new funds, when you want to buy a fund sponsored by the same general partner on the secondary market, they're going to return your call. And they don't have to tell Dan's team the same information and my team the same information, and some third party team we don't like the same information. They can distinguish among us based on their interests. There's no concept of insider trading or fair disclosure. So data capture, data analysis are absolutely critical to making underwriting decisions and the investment made in data and analytics is critical to success.

Jenna Dagenhart (51:55):

And obviously there's a lot of opportunity in this space. But Dan, what about some of the risks in private equity markets right now?

Daniel Wilk (52:03):

Yeah, I mean, the major risks are going to come down to underwriting, and the amount of capital that's certainly come into the space over the last, call it three to five to 10 years. Within the evergreen space, I think building out a diversified exposure really helps mitigate a lot of that risk. You're diversified across industry, vintage sponsor transaction type, but a lot of the direct deals that investors are engaged in, they're taking a little bit longer. They're taking a little bit longer to close, co-investment activities moving out from months at a time to now quarters at a time, you're going to see the slowdown, but then you'll experience the ramp up again as people come to terms with new valuations. As people look at businesses that are growing their crash flow revenues faster than multiples are compressing, there's going to be consistent deal flow.


So much like the risk and reward of public equities from a business perspective, the same will exist on the private side. However, you're not going to have the technical swings, the speculative premiums that come with, we'll call it AI and eight stocks. I think Jeremy mentioned it best. So that's where we would say, and that's where we're looking.

Jenna Dagenhart (53:10):

And bringing the conversation full circle here, as we learned in 2022, the 60/40 portfolio doesn't always necessarily cover everything. And many in the industry, including some of you on this panel today, have advocated for adding private equity to retirement accounts and target-date funds. How would this move benefit a broader group of people saving for retirement? And Bob, I know you're very passionate about this, so why don't you kick us off?

Bob Long (53:38):

Yeah, I'm happy to. Look, my father benefited from a defined benefit plan at the state of North Carolina, which was heavily invested in private markets and that supported his and my mother's retirement. If you are a public sector employee today, and you're in a defined contribution plan, a 401K plan, many of those also have access to private assets in their target-date fund. It's only private sector employees in defined contribution plans. Anybody who's in a DB plan has a lot of exposure and benefits. It's only private sector employees in DC plans that don't have exposure to the private markets. And consequently, in a world where, as we know, the market's moved away from defined benefit to defined contribution, and now investors or savers are responsible for their own retirement.


In that world, it is absolutely critical to achieve the results and be able to have a secure retirement that investors have access to the full range of investments, and independent research from Georgetown University and others have shown that a modest allocation to private assets over a 40-year typical working life within a target day fund can dramatically impact the amount of money people have to live on when they retire, or even more poignantly, they'll run out of money risk the probability that their savings don't match their longevity. In fact, the research has shown that risk can be brought down by half by very modest allocation. So it's a simple matter of benefiting our retirees and creating fairness across and leveling the playing field for private sector to find contribution savers with all other forms of savers that benefit from private markets in their 401k, in their pension plans through the defined benefit world. Jeremy, you want to correct me [inaudible 00:55:40]-

Jeremy Held (55:40):

Yeah, I mean, I couldn't agree more. I mean, this is something that Bob and I have been working on a lot, and it's a fairness issue. It's a retirement security issue. In this political climate, there are very few things that both parties can agree on, but I think retirement security for all Americans is one of them. And I think it would be one thing if private markets hadn't performed well, but you have two combinations, two factors here. You've got private markets used to be 1% of the capital markets, then there were three, then there were five. Depending upon how you define it, they're 12 to 15% of capital markets probably going to 20. So just eliminating a huge portion of the capital markets from eligibility is one thing, but to have that component be the best performing segment of the capital markets, it's really a miscarriage of the fiduciary duty to not allow that as part of the equation from a fairness standpoint. So I think that there's going to be some momentum there, and Bob's really done a great job leading that charge, but I couldn't agree more that it's an important issue.

Jenna Dagenhart (56:40):

Dan, I see you nodding your head. Any final thoughts that you'd like to leave our viewers with in terms of the future and direction that the industry is headed in?

Daniel Wilk (56:49):

No, I think it's phenomenal commentary by the panelists. Jeremy and Bob made great points across the board about this fairness issue. I think right now, there's real opportunity outside of this. To summarize all of our talking points in a sense, the wealth management community is really at an inflection point right now with more operationally friendly vehicles to access private equity coming to market in a variety of ways. Institutions have accessed private equity in a number of ways, typically factor tilt based off of size. Midcap, large cap, mega, stage, venture growth, buyout, or even sector. Hey, I want to own a infrastructure fund. I want to own... we mentioned business services and so forth. You're going to have more and more evergreen funds come to market that are targeted to allow the average investor to basically get off zero with respect to the best performing asset class in a portfolio.


Private equity is the largest based off of alternative AUM, but individual clients only make up 9% of that AUM. So I think all three of us would agree that number is going to continue to tick up sizably over the next three, five, and 10 years, and I think we're all pretty excited to participate in helping investors achieve better outcomes in a diversified growth format.

Jenna Dagenhart (58:03):

Well, Dan, Jeremy, Bob, thank you all so much for joining us. I wish we had time for more, but we better leave it there.

Bob Long (58:09):

Thank you.

Jeremy Held (58:10):

Thanks, Jenna.

Daniel Wilk (58:12):

[inaudible 00:58:12]. This was great.

Jenna Dagenhart (58:13):

And thank you to everyone watching this private equity masterclass. Once again, I was joined by Jeremy Held, managing director and portfolio manager at Bow River Capital. Bob Long, CEO at StepStone Private Wealth, and Daniel Wilk, executive director, client portfolio manager at FS Investments. And I'm Jenna Dagenhart with Asset TV.




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